What Is a down-And-Out Option?

A down-and-out option is a type of option in which the investor that owns the option cannot exercise it if the price of the security underlying the option falls below a certain level. This lower level is the barrier, which is why this option is also known as a down-and-out barrier. Essentially, the option becomes worthless once the price falls below the predetermined barrier, rendering all future price movements of the underlying useless once the barrier is reached. Since the existence of a barrier with a down-and-out option makes it much more risky, it can usually be bought for a discount compared to other options.

Options are investment vehicles which allow investors to speculate on the price of some underlying security, which is usually a stock, without actually owning it. There are call options, which give the owner the right to buy stock shares, and put options, which give the owner the right to sell stock shares. Normally, an option can be exercised once the underlying stock reaches a predetermined strike price. Barrier options, however, add a second price level which also factors into the worth of the option. One type of barrier option is a down-and-out option.

The distinguishing characteristics of a down-and-out option are that the barrier price is set below the current stock price and that the option becomes invalid once the barrier is reached. For example, a down-and-out call option might have a current price for the underlying of $130 US Dollars (USD) per share, a strike price of $150 USD per share, and a barrier price of $100 USD per share. If the price falls below $100 USD per share, the call option goes down and out and is invalid, even if the price subsequently surges past the strike price of $150 USD.

As a result of the way a down-and-out option is structured, the option seller can benefit in two ways. First, the underlying price might not reach the stock price prior to the option contract's expiration. In addition, the price may reach the barrier option. Both of those conclusions means that the option seller will have a worthless option, meaning that the seller pockets the premium paid by the buyer and has no further obligations.

Since the two possible negative outcomes for the buyer mitigate the value of a down-and-out option, a buyer must have some sort of compensation. As a result, these options often come at a lower price than options that do not have barriers. The premiums for down-and-out options also depend on the stock price's relation to the strike price and the barrier, as well as the volatility of the stock.