Exercisable or Knock-in Options
An exercisable or knock-in barrier option is an option that does not exist from inception, though a premium is paid up-front to the seller. The option is exercised, created or ‘in’ when the underlying asset reaches a certain predetermined level or barrier. This event can happen any time throughout the life of the option.
There are two main types of knock in options:
- The up and in put
- The down and in call
The up and in put
This is a simple European put which is exercised (gets knocked in) if, at any time during the life of the option the underlying asset reaches the barrier or in point. It is, in essence, the inverse of the up and out put. The holder of this asset owns an option with a payoff at expiration of zero unless at some time during the life of the put option the underlying asset rises above the barrier level. If it does, then the holder’s asset becomes a simple European put and has a payoff accordingly at expiration.
For example, a soybean producer wishes to secure today’s higher prices caused by the Midwest flooding. He could sell his inventory forward or purchase a European put option on the crop. Both will protect against a downward move in the price but only the European option will allow him to benefit from higher prices. Since he would like some flexibility with future higher prices, he could purchase a three month at the money European put option (with soybeans trading at $5.00 a bushel), but is discouraged by the high premiums. Instead he could purchase an up and in put with a barrier at $5.25 for 35% less premium. The producer now owns a European put struck at $5.00 that does not exist until $5.25 is reached. Once reached, the producer is able to lock in the prices at more favorable levels.
As in previous examples, the seller may lose in fast moving whipsaw markets. In addition, the producer is not hedged if prices decline without the barrier being activated. However, this option strategy reflects his market opinion in the cheapest and most flexible manner possible.
The second major type of knock-in barrier is the down and in call.
The down and in call
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