A knock-out option is a barrier option that becomes worthless (or “knocks out”) if the underlying asset reaches a predetermined barrier level during the option’s life. These exotic options automatically terminate when barriers are breached, providing cheaper alternatives to standard options with built-in risk limitations. Knock-out features reduce option premiums but eliminate protection if barriers are touched.

Knock-out options include up-and-out calls/puts (terminated when price rises above barrier) and down-and-out calls/puts (terminated when price falls below barrier). These instruments appeal to traders seeking reduced premium costs in exchange for accepting knockout risk. Barrier levels must be carefully selected to balance cost savings against knockout probability.

Real-world example: A trader sells EUR/USD up-and-out call options with 1.1200 strike and 1.1500 knockout barrier, collecting higher premiums than standard options while automatically eliminating obligation if EUR/USD rises above 1.1500.