With the help of knock-out certificates, opportunity-oriented and risk-taking investors can speculate on a large number of underlying assets or hedge their portfolio. We explain what to look for when trading knock-out products and how you can find the best knock-outs.
KNOCK-OUT CERTIFICATES – THE MOST IMPORTANT IN BRIEF
With a knock-out certificate, you as an investor can benefit several times from the price development of an underlying asset – thanks to the leverage effect, even with little capital.
With long-knock-out certificates you bet on rising prices, with short-knock-out certificates you speculate on falling prices.
In principle, the following applies: the higher the leverage factor, the greater the relative potential return in relation to the capital employed and the more likely it is that the product will be knocked out.
KNOCK-OUT CERTIFICATES – RECOMMENDATIONS & TIPS
If you want to trade knock-out certificates, you first need a securities account. Our depot comparison helps you to find a cheap provider.
Our recommendation: Use knock-out certificates as deposit protection or for short-term investments.
Product recommendation: Vontobel, JP Morgan, Société Générale and BNP Paribas, among others, offer numerous knock-outs.
WHAT ARE KNOCK-OUT CERTIFICATES?
Knock-out certificates are a specific type of leverage product. With these certificates, investors have the chance to use knockouts to speculate on various underlying assets (e.g. stocks, indices, currencies, commodities, etc.) with high levels of leverage and largely without the influence of volatility. The volatility influence, which is largely eliminated in contrast to classic warrants, is bought by a knock-out threshold, at which the knock-out certificates expire and, depending on the specific design of the paper, either a total loss or almost total loss of the capital invested can be suffered.
Knock-out certificates can give an investor enormous profit opportunities due to the leverage effect. Various issuers such as Société Générale, Vontobel, JP Morgan or BNP Paribas offer knock-out certificates. As with all investments, investors should keep the risks in mind. In this guide we explain everything that is important to know about knock-out products and explain the opportunities and risks of trading with these certificates.
If you are looking for the best knock-out certificate, you will learn more about it further down in this guide – this is how you will find the right product.
OPPORTUNITIES AND RISKS OF KNOCK-OUT PRODUCTS
Anyone wishing to invest in knock-out products generally has the choice between long-knock-out products and short-knock-out products. If you expect the price of the underlying asset to rise, you should invest in long knock-out products. On the other hand, if you expect prices to fall, investing in short knock-out products is worthwhile.
BENEFITS OF KNOCK-OUT CERTIFICATES FOR INVESTORS
With knock-out certificates, investors enjoy a risk of loss that is limited to the capital employed, i.e. buyers of knock-out certificates have no obligation to make additional payments, such as CFD or futures trading. In addition, knockouts sometimes offer very high leverage and are therefore an interesting investment vehicle for risk-conscious investors. Anyone who invests in knock-out certificates also benefits from low surcharges and discounts, a largely eliminated influence of volatility on the price of the certificate and the possibility of investing without a term limit and thus allowing leverage to work in the longer term.
DISADVANTAGES OF KNOCK-OUT CERTIFICATES FOR INVESTORS
Nevertheless, investors should keep an eye on the knock-out threshold of the selected certificates, which, even if they are briefly exceeded or fallen below, lead to a knock-out and thus to a total loss of the capital invested. In addition, the trading hours can also come to the detriment of the investor, namely, for example, exactly when the knock-out threshold is violated after the hours of trading, which would not have happened in regular trading and the knock-out certificate could also be knocked out after the hours of trading. Ultimately, depending on the issuer, the spreads of knock-out certificates on the individual underlyings also vary.
Tip: With knock-out products in particular, your investment success depends on the selection of the product. You should also research from which issuer you can get a good price. You can find a good selection at Vontobel, Société Générale, JP Morgan and BNP Paribas, for example.
HOW DO KNOCK-OUT CERTIFICATES WORK?
The way knock-out certificates work is to a certain extent comparable to the way warrants work. In the case of classic warrants, however, a term has expired, whereas many knockouts are issued by the issuer without a term limit. The big simplification with knock-outs compared to warrants is that the price of a knock-out essentially depends on the difference between the current price of the underlying and the strike price.
In contrast, with warrants, other influencing factors, such as in particular the volatility of the underlying and the remaining term (time value), have an impact on the price of the warrant. Investors should be careful with knockouts with no term limit, especially if they want to hold them for longer. Here, the issuers usually adjust the base price regularly to the financing costs and dividend income, so that changes over time may arise with regard to the knock-out threshold. In the following, a knock-out call and a knock-out put on the German stock index DAX will be used to explain how knock-out certificates work.
HOW LONG-KNOCK-OUT PRODUCTS WORK – AN EXAMPLE
If the DAX has a positive opinion, an investor who is willing to take risks can buy a knock-out call through which he can leverage the performance of the share index. The leverage that can be selected depends on the current level of the underlying asset (DAX) and the defined strike (base price) of the knock-out call. The following applies: the closer the underlying comes to the strike, the higher the leverage. Sure: the closer the knock-out threshold, the less buffer there is until the possible total loss of the capital employed, the higher the chance of profit must be – which then appears to be justified by the high leverage. Levels of more than 100 are not uncommon with common indices.
However, the strike often also represents the so-called knock-out threshold. If the price of the underlying asset fell below this specified threshold, the investor would have to suffer a total loss of the capital invested. If, on the other hand, the price of the knock-out threshold is slightly upstream of the strike when the call is made, the investor would get back a small amount of their capital if the value fell below the threshold – but usually only a minimal amount.
Assume the DAX is currently at 11,500 points and an investor expects the DAX to rise in the coming weeks with a target price of 12,000 points. As a massive support zone and stop, the investor makes the area around 11,400 points. He decides to buy a knock-out call with a strike and an identical knock-out threshold at 11,350 points. The surcharge that may be encountered in practice is not taken into account in the calculation example.
- Product: Knock-out call on the DAX
- Issuer: XY Bank
- Strike (base price): 11,350 points
- Knock-out threshold: 11,350 points
- Subscription ratio: 0.01
- Currency: Euro
- Duration: open end
The price of the knock-out call at the time of purchase is then calculated as follows:
(Price of the base value minus strike) multiplied by the subscription ratio = (11,500 points – 11,350 points) x 0.01 = 1.50 euros.
Thus, the knock-out call would make almost 77 times the DAX, in both a positive and a negative direction. Specifically, this means, for example: If the DAX rises / falls by one percent, the knock-out call rises / falls by 76.7 percent in the same time. For example, if the DAX rises / falls by two percent, the knock-out call rises by 153.4 percent. If the DAX fell by two percent, the knock-out threshold would be reached and the certificate would fall to EUR 0.00 (total loss 100 percent).
If the investor’s scenario occurs and the DAX rises to 12,000 points and thus makes 4.35 percent profit, the knock-out call would occur in the same time (12,000 points minus 11,350 points) multiplied by 0.01 = 6.50 Euro or just climb by 333.33 percent. A government profit with a small increase in the underlying DAX.
HOW SHORT-KNOCK-OUT CERTIFICATES WORK – AN EXAMPLE
Assume the DAX is currently at 11,500 points and an investor expects the DAX to fall in the coming weeks with a target price of 11,000 points. As a massive resistance zone and stop, the investor makes up the area around 11,600 points. He decides to buy a knock-out put with a strike and an identical knock-out threshold at 11,650 points. The calculation example does not take into account the discount that may be encountered in practice.
- Product: Knock-out put on the DAX
- Issuer: XY Bank
- Strike (base price): 11,650 points
- Knock-out threshold: 11,650 points
- Subscription ratio: 0.01
- Currency: Euro
- Duration: open end
The price of the knock-out put at the time of purchase is then calculated as follows:
(Strike minus price of the base value) multiplied by the subscription ratio = (11,650 points – 11,500 points) x 0.01 = 1.50 euros.
For the current leverage at the time of buying the knock-out put, the following formula results in a value of: (current price of the underlying asset multiplied by the subscription ratio) divided by the price of the knock-out put = (11,500 points x 0.01) / 1.50 euros = 76.7.
Thus, the knock-out put would make almost 77 times the DAX, in both a positive and a negative direction. Specifically, this means, for example: If the DAX falls / rises by one percent, the knock-out put rises / falls by 76.7 percent in the same time. For example, if the DAX falls / rises by two percent, the knock-out put increases by 153.4 percent. If the DAX rose by two percent, the knock-out threshold would be reached and the certificate would fall to EUR 0.00 (total loss 100 percent).
If the investor’s scenario occurs and the DAX falls to 11,000 points and thus makes a 4.35 percent loss, the knock-out put would occur in the same time (11,650 points minus 11,000 points) multiplied by 0.01 = 6.50 Euro or just climb by 333.33 percent.
If an investor were able to buy a knock-out put close to the knock-out threshold (e.g. in the example with a DAX level of 11,630 points) without subsequently resulting in a total loss, the leverage would be over 580 {( 11,630 x 0.01) / 0.20} exorbitantly high and the chance of winning gigantic. If the DAX target price is reached, which is around 4.4 percent lower than at the time of purchase, a profit of around 2,500 percent would be possible, i.e. around 25 times the capital employed.
HOW TO FIND THE BEST KNOCK-OUT CERTIFICATES
As an investor, you can trade knock-out certificates through a broker of your choice; various issuers such as Vontobel, JP Morgan, BNP Paribas or Société Générale offer different knock-out certificates. It is best to check the conditions of your broker, sometimes custody account providers open certificates from a wide variety of issuers at discounted and exclusive conditions.
If you want to trade knock-out certificates, you should develop a differentiated market assessment before buying, because the short knock-out product is only suitable for falling markets – the more the price of the underlying asset falls, the better. In contrast, a long knock-out product is only suitable for rising markets.
A first look should apply to both types of knock-out, the remaining term and the knock-out barrier. If you are unsure about the period of your price forecast, you generally choose an open-end product with no term limit – if it then takes longer before the desired scenario occurs, investors do not have to “roll” their position (i.e. sell the short-term product and a longer-term one to buy).
Open-end products also have an advantage in the worst-case scenario: If there is a knockout, all financing costs were only paid pro rata temporis, i.e. according to the holding period – with a runtime product, on the other hand, the entire financing costs were almost in advance of the product price paid and are therefore lost in the event of a knock-out.
Caution: By choosing the right knock-out barrier, investors decide on the leverage factor and thus the risk of the investment. The lower the knock-out barrier, the closer it is to the current price of the underlying and, consequently, the higher the leverage factor of the product. The higher the leverage factor, the greater the relative potential for return in relation to the capital employed, but the more likely it is that the product will be knocked out.
Our recommendation: Knock-out products can be used to implement portfolio strategies with low leverage as well as highly speculative, short-term trading strategies. For example, if you want to hedge part of your equity capital in the short term without reducing your actual position, you could compare it with an equivalent amount of knock-out products. The choice of the right knock-out barrier is based on the individual willingness to take risks. With this measure, unrealized profits of a position in the underlying can be “frozen”.
KNOCK-OUT CERTIFICATES – IN BRIEF
With the help of knock-out certificates, investors can speculate on a large number of underlyings on the long or short side or hedge their portfolio against price losses. Speculation can be implemented with knockouts, depending on the willingness to take risks, with very high levers in the hundreds.
However, due to the creative design of leverage certificates with a knockout threshold by the issuer, an individual comparison with your personal investment preferences and your willingness to take risks is required before purchasing.
PRODUCT AND EQUIPMENT VARIANTS
REDUCED KNOCK-OUT TIMES / SMART TURBO
Knock-out products are also available with shorter knock-out times. In this product variant, the knock-out barrier is only active on the basis of the closing price of the underlying asset – the product cannot therefore be “knocked out” during the day. Should the price fall below the barrier during trading hours and recover before the closing auction, the product will not be worthless or knocked out with residual value, but will continue to exist.
Important: For this additional security of not being exposed to strong price fluctuations intraday, an additional risk premium in the form of a surcharge is added to the price of the knock-out product.
EXTENDED KNOCK-OUT TIMES / X-TURBO
For certain underlyings, knock-out products are also available with extended knock-out times, e.g. long knock-out products on the X-DAX. The X-DAX is calculated from 8:00 a.m. to 9:00 a.m. and from 5:30 p.m. to 10:00 p.m. – i.e. whenever the Xetra trading system is closed. The X-DAX calculation is then based on the DAX future. Since the long knock-out product can still “knock out” when prices fall, even after the end of official trading hours – for example in response to negative developments on the US stock exchanges – the risk premium calculated by the issuer for the gap risk falls accordingly lower off. Investors benefit from a lower price than with traditional products or those with shorter knock-out times.
WHO ISSUE KNOCK-OUT CERTIFICATES?
Knock-out certificates are issued by banks; the issuers of certificates are also referred to as issuers. As an investor, you will find various knock-out certificates from providers such as Société Générale, Vontobel, JP Morgan and BNP Paribas. The legal shell of a knock-out certificate is the bearer bond. Depending on the issuer, various names for knock-out certificates can be found, e.g. Sprinter, Turbos, Waves, etc. The design can be varied. Usually, a knock-out certificate is issued on a base value (e.g. stock index) and given a so-called strike (base price), which is important for calculating the certificate price and leverage, among other things. Some knockouts have a certain term and can only be knocked out during regular exchange trading, while others are issued without a term limit (open end) and can possibly also be knocked out over the counter. Many variations are possible, depending on the individual taste of the investor.
HOW AND WHERE CAN KNOCK-OUT CERTIFICATES BE TRADED?
An investment in knock-outs can be made for securities account holders with a speculative attitude on stock exchanges or in over-the-counter trading directly with the issuer. When trading certificates on exchanges, fees and brokerage fees are charged depending on the broker. In the case of direct trading through the issuer, there is no brokerage fee, as the transaction is processed without the assistance of a broker. Some brokers also offer free direct trading of certificates in cooperation with some issuers.
Note: Here, however, a minimum volume or a minimum turnover must often be achieved, i.e. at least 1,000 euros must be invested in certificates, for example. In both on-exchange and over-the-counter trading, investors should definitely place limit orders in order not to experience any negative surprises on their buy or sell statements. After buying a knock-out, setting a stop-loss could protect against excessive losses.