Define Barrier Option

What does it mean to have a barrier option?

A barrier option is a form of derivative in which the reward is contingent on the underlying asset reaching or exceeding a defined price. A barrier option can be a knock-out, which means it will expire worthless if the underlying price rises over a particular level, restricting gains for the holder and losses for the writer. It might also be a knock-in, which means it has no value until the underlying price hits a specified level.

The Fundamentals of a Barrier Option

Because barrier options are more sophisticated than ordinary American or European options, they are called exotic. Because their value fluctuates when the underlying value changes during the option's contract period, barrier options are also classified as path-dependent options. In other words, the payment of a barrier option is determined by the price path of the underlying asset. When a price point barrier is crossed, the option becomes worthless or is activated. Knock-in and knock-out barriers are the most common types of barriers.

Alternatives to the Knock-In Barrier

A knock-In option is a sort of barrier option in which the rights connected with it are only created when the price of the underlying asset hits a certain threshold during the option's life. Once a barrier is installed or established, the choice stays available until it expires.

Up-and-in and down-and-in knock-in choices are two types of knock-in options. Only if the price of the underlying asset increases over the pre-specified barrier, which is set above the underlying beginning price, does an up-and-in barrier option become active. A down-and-in barrier option, on the other hand, only exists when the price of the underlying asset falls below a pre-determined barrier set below the underlying original price.

Alternatives to the Knock-Out Barrier

Knock-out barrier options, unlike knock-in barrier options, expire if the underlying asset exceeds a barrier during the option's existence. There are two types of knock-out barriers: up-and-out and down-and-out. When the underlying security rises above a barrier established above the underlying starting price, an up-and-out option ceases to exist. When the underlying asset falls below a price threshold specified below the underlying original price, the down-and-out option expires. The option is knocked out, or cancelled, if the underlying asset crosses the barrier at any point during the option's existence.

Optional Barriers of Other Types

Other variations of the above-mentioned barrier solutions are conceivable. The following are three of them:

1. Both knock-out and knock-in barrier options can include a provision to offer refunds to holders if the option does not reach the barrier price and hence becomes worthless. Rebate barrier choices are what they're called. In such circumstances, rebates are given in the form of a percentage of the premium paid by the option holder.

2. Options for a Turbo Warrant Barrier: Turbo warrants are a sort of down-and-out option that is highly leveraged and characterised by minimal volatility. They are mostly traded in Europe and Hong Kong. They're popular in Germany, where they're employed for speculating.

3. The contract is not triggered if the barrier price is reached in a Parisian option. Instead, for the contract to kick in, the underlying asset's price must spend a certain period of time beyond the trigger barrier price. In this form of option, the length of time the underlying asset's price spends outside and inside the barrier price range is measured.

Trade Barrier Options for a Variety of Reasons

Barrier options offer lower premiums than equivalent options without barriers because they have more requirements built in. If a trader feels the barrier will not be breached, they may choose to buy a knock-out option, which has a smaller premium and is unlikely to be affected by the barrier condition.

Knock-in options can be used by someone who wishes to hedge a position but only if the underlying price reaches a certain threshold. The barrier option's reduced premium may make it more desirable than non-barrier American or European alternatives.

TAKEAWAYS IMPORTANT

• Barrier options are a form of option where the payoff is contingent on the option reaching or exceeding a predetermined barrier price.

• Barrier options are less expensive than normal options and can be used to hedge holdings.

• Knock-out and knock-in barrier options are the two most common forms of barrier choices.

Barrier Options Examples

Here are two instances of the above-mentioned barrier possibilities.

Option for a Knock-In Barrier

When the underlying stock is trading at $55, an investor purchases an up-and-in call option with a strike price of $60 and a barrier of $65. Until the underlying stock price rose over $65, the option would be worthless. While the investor pays for the option and the possibility of it being lucrative, the option is only valid if the underlying hits $65. If it doesn't, the option will never be activated, and the option buyer will lose the money they paid for it.