What is a Barrier Option?
A barrier option is a type of derivative where the payoff depends on whether or not the underlying asset has reached or exceeded a predetermined price. These options can be classified as either knock-in or knock-out. They are considered exotic options due to their complexity compared to standard American or European options, and are classified as path-dependent because their value fluctuates with the underlying asset’s price changes during the option’s contract term.
Key Takeaways
- Barrier options are a type of exotic derivative in which payout depends on whether the option has reached or exceeded a predetermined barrier price.
- They offer lower premiums compared to standard options and are used to hedge positions.
- There are primarily two types: knock-out and knock-in barrier options.
- The rights associated with a knock-in option come into existence when the underlying security’s price hits a specified barrier during its life.
- A knock-out barrier option ceases to exist if the underlying asset reaches a barrier point during the option’s life.
Types of Barrier Options
Barrier options are typically classified under two main categories:
Knock-in Barrier Options
A knock-in option is activated only when the underlying security’s price reaches a specified barrier during the option’s term. Knock-in options might be further sub-categorized as up-and-in or down-and-in:
- Up-and-in: Activate when the underlying asset’s price rises above the pre-specified barrier.
- Down-and-in: Come into existence when the underlying asset’s price falls below the pre-determined barrier.
Knock-out Barrier Options
In contrast, knock-out barrier options terminate if the underlying asset’s price hits or exceeds a certain barrier during the option’s life. They too have up-and-out or down-and-out variants:
- Up-and-out: Cease to exist when the asset’s price moves above a barrier set above the initial price.
- Down-and-out: Terminate if the price falls below a barrier set below the initial price.
Other Types of Barrier Options
Rebate Barrier Options
Both knock-out and knock-in barrier options may offer rebates if the option becomes worthless before meeting the barrier condition. The rebates generally represent a percentage of the premium paid by the holder.
Turbo Warrant Barrier Options
Traded mainly in Europe and Hong Kong, Turbo warrants are a highly leveraged type of down-and-out option characterized by low volatility and are popular for speculative purposes in markets like Germany.
Parisian Options
Unlike standard barrier options, a Parisian option requires the underlying asset’s price to spend a specific duration beyond the barrier for the contract to be triggered, providing a unique mechanism for price tracking.
Reasons to Trade Barrier Options
The additional conditions of barrier options make them less expensive compared to non-barrier options due to lower premiums. Traders believing that the barrier won’t be reached might choose a knock-out option to hedge positions at a lower cost. Conversely, investors wishing to hedge only when a specified price is hit might find knock-in options appealing due to their cost-effectiveness over non-barrier counterparts.
Examples of Barrier Options
Knock-in Barrier Option
Suppose an investor purchases an up-and-in call option with a strike price of $60 and a barrier of $65, while the underlying stock trades at $55. The option activates when the stock price exceeds $65. If the stock doesn’t reach $65, the option never triggers, and the investor loses the premium paid.
Knock-out Barrier Option
Consider a trader who buys an up-and-out put option with a barrier of $25 and a strike price of $20, while the underlying asset trades at $18. If the asset price rises above $25 during the option’s lifetime, the option becomes worthless, regardless of any subsequent price drops.
Insight into Exotic Options
Exotic options are derivatives that offer more intricate contract conditions compared to standard American and European options. They are designed to meet specific investment strategies and risk tolerance levels.
Distinguishing American and European Options
American options allow execution any time before or on the expiration date, whereas European options only permit execution on the expiration date itself.
Benefits of Barrier Options
The primary benefit of barrier options is their lower premiums, making them attractive for buyers. Additionally, they offer customized risk management and strategic flexibility in financial planning.
The Bottom Line
Barrier options, characterized by their dependency on price barriers, present a flexible and cost-effective approach to options trading. The two main types are knock-in and knock-out, with other variations such as rebate and Parisian options available. Their primary advantage is reduced premiums compared to standard options, offering significant strategic value to traders and investors.
Related Terms: Derivative, Underlying Asset, American Option, European Option.
