Knock-out Option Risk

Knock-out option risk is the specific danger that a derivative contract will be abruptly terminated before expiration if the underlying asset price touches a specified barrier. This creates a discontinuous risk profile where the delta of the position can shift drastically as the price approaches the barrier.

For market makers, this means that hedging requirements can change instantly, leading to significant slippage or the need for rapid position adjustments. In crypto, where price action is often jumpy, the risk of a knock-out event is amplified by low liquidity and high volatility.

Pricing this risk requires sophisticated modeling of the probability of hitting the barrier and the potential for gap risk, where the price jumps past the barrier level.