Riddle time: what is an option that was never really an option?
Sounds like a meditation on the perception of free will in a universe that might be deterministic on a subatomic level. But...no. We're talking about financial markets.
In financial terms, options give investors the right, but not the obligation, to buy or sell an underlying asset (a stock or commodity or whatever) at a set price within a set period of time. So...you might purchase an option to buy 100 shares of XOM stock at $80 a share, with the contract expiring in June.
A knock-in option generally works like a normal option, except it has a barrier price built in. If the underlying asset never reaches a certain price threshold, then the knock-in option never becomes a true option. When it expires, it's like it never existed. However, if the minimum price threshold is met, the contract becomes a regular option.
You buy a knock-in option for XOM at $80 a share, with the contract expiring in June. It has a barrier price of $75 a share. The stock is currently trading at $70. If June comes around and the stock is trading at $73, the option doesn't exist. The contract just disappears into the gloaming, like a gauntleted Thanos just snapped his fingers.
However, if the stock gets to $76 in late May, then the contract becomes a live option. Now you just need it to rise above $80, so you can exercise the option and book a profit.
Related or Semi-related Video
Finance: What are stock options in 90 se...0 Views
Finance allah shmoop what are stock options in ninety seconds
or less Here's a stock ibm not the tech company
This one makes an anti constipation drug It's trading at
one hundred eighty bucks a share Okay so here's an
option of buy a share of ibm anytime in roughly
the next three months For one hundred ninety dollars a
share it's called a call option If you really believe
the ibm will go to say two hundred dollars a
share in the next three months well you'd be what's
called ten dollars in the money then or then have
a stock option or call option with a strike price
of one hundred ninety dollars which would then have intrinsic
value of ten bucks a share On the other end
of the buy sell desk is the gal willing to
sell you that call option for three bucks Three bucks
a premium So gut check time Would you pay three
dollars for the right to buy a share if ibm
for ten dollars higher than where the stock's trading now
today Meaning that to break even in the next three
months the stock has to trade all the way up
from one hundred eighty dollars a share to one hundred
ninety three dollars a share jobs for you to get
your money back but it goes to two hundred two
share Well if you sell that option you'll have invested
three bucks a share for a net return of seven
bucks in just three months or less And yes we're
ignoring commissions and taxes here because well in problems like
this or just a in the book but three dollars
into seven only three months Yeah that's a great score
You'd have more than doubled your money And on an
annualized return basis that's over a nine hundred percent dish
return really good score but with a much more likely
case that you spend three bucks to buy the option
and it expires totally worthless And then you've lost your
entire investment in that option So that's a call option
It's evil twin is a put option So whereas a
call options the rightto by a security to set price
by a certain set date a put option is the
right to sell that option We'd go into more detail
here but we're promised ninety seconds
Up Next
What is a put option? A put option is a type of contract that lets the investor sell shares of a stock at a certain price and within a window of ti...
What is a call option? A call option is a type of contract that lets the investor buy shares of a stock at a certain price and within a window of t...
What are Interest Rate Options? Interest rate options are call and put option derivatives created to manage fixed income portfolio risk and specula...