A knock out (ako) is a European vanilla with an American barrier.
The barrier can only be hit (immediately knocking out, or terminating, the option) if the option is moving out of the money, or losing value.
If during the option's life the barrier:
Is not hit, the payout is that of the underlying vanilla option.
Is hit, the underlying vanilla option is knocked out and there is no payout.
There are two types of regular knock out options:
Normal (or out of the money) knock out
In this type of knock out, you define the barrier for a:
Call (also known as a down and out call) below the underlying asset and the strike (the strike itself should be above the underlying asset).
Put option (also known as an up and out put) above the underlying asset and the strike (the strike itself should be below the underlying asset).
This means that as the barrier is reached the underlying vanilla option has no intrinsic value and a relatively low price.
An in the money knock out
In this type of knock out, you define the barrier for a:
Call, above the strike and below the underlying asset.
Put, below the strike and above the underlying asset.
This means that as the barrier is reached the underlying vanilla option has intrinsic value and a relatively high price.
This option is classed as a regular knock out because the underlying vanilla option is moving out of the money or losing value when it is knocked out. It should not be confused with the reverse knock out, where the option is knocked out as it is moving in to the money or gaining value.