The knock-out price, often referred to as the knock-out level, is a pre-determined price point set by a trader for a Knock-Out trade. This crucial level acts as a built-in risk management tool, automatically closing the trade to limit potential losses if the underlying market price reaches it.
Understanding Knock-Outs
Knock-Outs are a specific type of Contract for Difference (CFD) that are traded on an option. They offer a way to speculate on price movements of an underlying asset without owning the asset itself. A defining characteristic of Knock-Outs is their direct correlation with the underlying market:
- One-for-One Movement: For every point the underlying market moves, the price of the Knock-Out moves by the exact same amount. This direct relationship simplifies tracking its value relative to the underlying asset.
The Function of a Knock-Out Level
The primary purpose of setting a knock-out level is to manage risk effectively. It functions similarly to a guaranteed stop-loss order, ensuring that your maximum potential loss on a trade is capped.
- Automatic Closure: When the underlying market price reaches your chosen knock-out level, the trade is automatically closed, or 'knocked out'. This prevents further losses beyond your pre-set tolerance.
- Risk Management: By defining your knock-out level at the outset, you establish your maximum acceptable risk for that particular trade, making it a powerful tool for disciplined trading.
Practical Example
Imagine you are trading a Knock-Out on a stock currently priced at $100. You believe the stock will go up, so you buy a Knock-Out. To protect yourself from a significant downturn, you set your knock-out level at $95.
- If the stock price rises to $105, your Knock-Out trade profits.
- However, if the stock price unexpectedly falls and reaches $95, your trade is automatically closed, or "knocked out," at that level. This ensures your loss is limited to the difference between your entry price and the $95 knock-out level, plus any associated costs.
Key Aspects of Knock-Out Levels
The table below summarizes the key features and functions of a knock-out level:
| Feature | Description
