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Knockout is a derivative that pays a vanilla option at expiration but evaporates if the underlying price goes through a specific barrier before the expiration. If the barrier breach happens, this is known as a “knockout event”. The event can result in either a zero payoff or a payoff of a fixed, pre-specified rebate. The rebate, if stipulated, is paid either at expiration or shortly after the knockout event.

Knockouts are very liquid in FX, actively traded in equities and somewhat less popular in commodities. Traders distinguish between

- regular knockouts (one barrier) versus double knockouts (two barriers above and below the initial price of the underlying),
- regular knockouts (active barrier throughout the life of the instrument) versus window knockouts (a barrier active only for a fraction of the life of the instrument).

The second function of knockout is expressing a view on the skewness (asymmetry or risk reversal) of the price of the underlying asset. Imagine the knockout barrier is below the initial price of the underlying. Then the volatility is more dangerous if the underlying asset goes down and not up. The difference between the volatility above and below is directly linked to the difference between the fatness of the right and left tails of the underlying distribution. So it is directly linked to the skewness of the underlying distribution. If the trader thinks that the true skewness is not what is perceived by the market then he/she may buys/sell the knockout.

Knockouts are traded over the counter (OTC). So you will have to pick up the phone and call somebody to coin the agreement. The biggest market makers in the field are investment banks and big hedge funds. Many prime brokerage services will allow you to trade knockouts on the market making or price taking side. For the list of top prime brokerage companies please refer to the link below.

Bouzoubaa, M. (2010). Exotic Options and Hybrids: A Guide to Structuring, Pricing and Trading. Wiley.

de Weert, F. (2008). Exotic Options Trading. Wiley.

Lipton, A. (2001). Mathematical Methods for Foreign Exchange: A Financial Engineer's Approach. World Scientific.

Nelken, I., ed (1996). The Handbook of Exotic Options: Instruments, Analysis and Applications. McGraw-Hill.

Clark, I. J. (2011). Foreign Exchange Option Pricing: A Practitioner's Guide. Wiley.

Heston, S. L. (1993). A Closed-Form Solution for Options with Stochastic Volatility with Application to Bond and Currency Options. The Review of Financial Studies 6, 327-343.

Carr, P., & Liuren W. (2007). Stochastic Skew in Currency Options. Journal of Financial Economics 86, 213-247.

Broadie, M., Glasserman, P. & Kou, S. G. (1999). Connecting discrete and continuous path-dependent options. Finance and Stochastics 3, 55-82.

Gatheral, J. (2006). The Volatility Surface. John Wiley & Sons, New Jersey.

Taleb, N. (1997). Dynamic Hedging: Managing Vanilla and Exotic Options. Wiley Finance, New York.

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- Wilmott.com

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