What are double barrier options and how do they work?

Summary: 

Double barrier options are a unique kind of exotic option with two set prices, one above and one below the current market rate. They can either activate (knock-in) or deactivate (knock-out) when the market reaches a specific price. These options are for traders who want to manage risks in unstable markets or to cash in on price changes. 

Options open doors to diverse financial strategies. These financial contracts allow investors to buy or sell an asset at a pre-specified price and time. Investors use options to manage risks, bet on markets, or generate additional profit. However, not all options are the same. Some are simple, while others, such as exotic options, offer special features and pay-offs.

One of the exotic options that we're going to delve into today is the double barrier option. Goldman Sachs introduced this exotic option in the late 1980s. Their aim was to create customised contracts for their clients, offering them more flexibility and variety. Since then, double barrier options have gained popularity among traders, especially those who predominantly deal in commodities, currencies, or stocks known for high volatility or significant price fluctuations.

In this blog, we will not only explain what double barrier options are but also talk about their different types and how they operate in the financial market. So let’s begin!

What are double barrier options?

Barrier options are a type of exotic option that has a price trigger, also known as a barrier that affects the option’s value. A barrier option can either start or stop working when the price of the underlying assets (commodities, currencies, indices, or stocks) reaches or crosses the barrier level. Barrier options depend on not only the final price of the asset but also the path that the price takes. Therefore, they are more complex and risky than plain options, but also cheaper and more profitable. Traders and investors use barrier options to benefit from market volatility or protect themselves from unwanted price movements.

Double barrier options are influenced by two barriers or trigger points, which determine the option's behaviour based on the underlying asset's price movement. To delve deeper into the various types, it's crucial to understand the terms 'knock-in' and 'knock-out'.

• Double knock-in: This option becomes active only when the asset price reaches either of the two barriers. Before that, it was dormant and had no value. Once activated, it behaves like a regular option and pays off at expiration. Double knock-in options are cheaper than regular options because they have a lower chance of being profitable, as they need to cross two barriers to start working.

• Double knock-out: This option starts as active and works like a regular option. However, it becomes inactive and worthless if the asset price hits either of the two barriers. Double knock-out options are more expensive than regular options because they have a higher chance of being profitable, as they need to avoid two barriers to keep working.

Different types of double barrier options

The following are the four types of double barrier options:

• Up-and-in: This is a knock-in option for oil that activates when oil's price rises to an upper barrier. For instance, if oil is currently priced at INR 100 per litre and an upper barrier is set at INR 110, the option would spring into action when oil's price reaches INR 110.
• Down-and-in: Another knock-in variant, this option becomes active when the asset's price drops to a lower barrier. Here the option becomes active when silver's price drops to a lower barrier. If silver is currently priced at INR 100 per gram and the barrier is at INR 90, the option would activate when silver's price dips to INR 90.
• Up-and-out: A knock-out option, it starts active but deactivates when the asset's price climbs to an upper barrier. If Company XYZ's stock starts trading at INR 100 per share and the upper barrier is set at INR 110, the option would become inactive the moment the stock price touches INR 110.
• Down-and-out: This knock-out option is initially active but switches off when the asset's price descends to a lower barrier. Suppose a property starts with a valuation of INR 100 lakhs and there's a barrier at INR 90 lakhs, the option would become inactive only once the property's value hits INR 90 lakhs.

How do double-barrier options work?

Suppose an investor buys a double knock-out put option on the NIFTY 50 index with the following parameters:

• Strike price: 20,000
• Lower barrier: 19,000
• Upper barrier: 21,000
• Expiration date: December 31, 2023
• Premium: 200

This option gives the investor the right to sell the NIFTY 50 index at 20,000 on December 31, 2023, as long as the index does not touch or go below 19,000 or above 21,000 before that date. If the index touches either barrier level, the option will expire worthless and the investor will lose the premium paid.

The payoff of this option (the amount the holder pays or receives at expiration) depends on the price of the NIFTY 50 index at expiration. The following table shows some possible scenarios and outcomes:

As we can see from the table, the investor can only make a profit (option payoff-premium) if the index stays within a narrow range between the lower barrier and the strike price. If the index moves too much in either direction, the option will be knocked out and become worthless. This option is suitable for investors who expect low volatility in the underlying asset and want to limit their upside risk.

Wrapping up: Points to remember 

• Double barrier options are a type of exotic option that has two barrier prices, one above and one below the current market price.
• These options can be either knock-in or knock-out, depending on whether the option becomes active or inactive when the price reaches a certain level.
• Double barrier options are more complex than traditional options and can be harder to price and understand. That's why it's important to carefully consider the risks before getting involved. 

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