What is a Barrier Option? Definition and Types
Barrier options are exotic options where the payout is dependent on the option reaching or surpassing a prefixed price. Option buyers can leverage its lower premium while option sellers prefer it due to the low risk factor. In this article, we will deep dive into understanding barrier options and its types.
Investors leverage options to earn profits based on predictions about whether a particular stock will grow in value or not. This helps investors enjoy profits and boost their portfolios. However, there are choices for an investor beyond the typical call and put options, one of them being the barrier option.
A barrier option is a derivative option contract whose payoff is dependent on whether the underlying asset reaches or crosses a price that’s predetermined in the options contract. A barrier option is more complicated than a simple call or put. Moreover, barrier options do not become effective until a particular specified price, also known as the barrier price, has been reached.
Barrier options: How do they work?
Barrier options are quite the same as traditional puts and calls. The participants agree on several terms related to the contract such as the price, the strike price, the expiration date, and the barrier price. The option holder then has the option but is not obligated to exercise the contract. However, barrier options add more terms and conditions as to when the contract can be exercised based on alterations in the underlying stock’s price.
A classic example
Let us assume that Jack sells barrier option with a call option to Carrie for shares of a particular company (ABC) with a strike price and barrier price of $50 and $55, respectively. Carrie can exercise the option at any time, and she would enjoy a profit any time the company hits a price over $50. However, since a $55 barrier exists, she cannot exercise the option until ABC increases above $55. This not only limits her choices but also provides Jack the opportunity to not lose funds.
Once the barrier price is reached, both in options and out options are available. The options start out to be active and become non-exercisable if the barrier price is reached.
The different types of Barrier Options
Knock-in Barrier Options
A knock-in barrier option means the related rights start when an underlying asset hits a price point. Knock-in means that the holder has the right to exercise the option only when or after the price strikes a specific level in the open market.
If the knock-in price bar is reached at any time during the barrier option's lifespan, then it turns into a vanilla option. The pricing is then adjusted accordingly.
The knock-in barrier option expires worthless if the knock-in price level is not reached. There are other divisions to this as well, such as
- Up-and-in or
While the up-and-in barrier option allows contracts to begin only when the underlying asset’s price surpasses the prefixed price barrier, it becomes valid if the underlying asset's value declines below the predetermined barrier price in a down-and-in barrier option.
Knock-out barrier option
Here, the validity drops when a barrier is reached by the asset within the contract lifespan. This can again be split up into
- Up-and-out or
Up and out is when the security surpasses a preset barrier that’s above the initial price of the underlying.
On the other hand, a down-and-out option is not valid if the asset drops below the barrier. In this case, the barrier is set beneath the initial pricing of the underlying asset.
If an asset touches the barrier within the life of the option, then the option is terminated or cancelled.
Here are a few other kinds of barrier options.
Parisian barrier options: It has both time and price as key variables doesn’t have any effect on the contract if the barrier price is reached. However, for the contract to work, the underlying asset’s price must spend a predefined time that is over the trigger barrier price. The time spent by the underlying asset’s price outside and within the barrier price band is measured in this option.
Turbo Warrant Barrier Options: On the other hand, Turbo Warrant Barrier Options are a kind of down-and-out option that have low market volatility. They are widely used by traders for speculation particularly across Hong Kong and Europe and are extremely famous in Germany.
Rebate Barrier Options: A provision to offer rebates to holders can come in the case of both knock-in as well as knock-out barrier if the option becomes worthless and doesn’t arrive at the barrier price point. These are typically a percentage of the premium paid by the option holder and are called rebate barrier options.
Barrier options are perfect for option sellers due to the low degree of risks involved. Also, option buyers can leverage its lower premium and you get the opportunity to customize the contract as well. They are exotic options and can be complex if you lack a deeper understanding. Barrier options are not traded on exchanges widely but are traded over the counter. If you are a pro trader, then you might be interested but do consider the challenges that barrier options come with.