A barrier option is a type of derivative option contract, the payoff of which depends on the value of the underlying asset. In other words, the payoff only comes into effect if the asset underlying the barrier option’s reached or exceeded a predetermined price specified in the option contract.
A barrier option can expire worthless (knock-out option) should the price of the underlying asset exceed a certain price, thus limiting profit for the option holder and limiting losses for the option writer (seller). The barrier option can be a knock-in option, which means it lacks any value until the moment the underlying asset strikes a particular price.
How Does a Barrier Option Work?
A barrier option is considered an exotic option as it comes with more features than regular American and European options. Barrier options are also referred to as path-dependent options since their value fluctuates along with the value of the underlying assets.
The option can be exercised when the price of the underlying asset crosses a predetermined price point barrier.
Classification of Barrier Options
Barrier options are classified into the following:
1. Knock-in barrier option
A knock-in barrier option is a barrier option where the associated rights commence once an underlying asset reaches a certain price. It means the holder can exercise the option only at and after the moment the price hits a particular level in the open market.
If the knock-in price level is hit anytime during the life of the barrier option’s contract, then it becomes a vanilla option and is priced appropriately. If the knock-in price level is never reached, the knock-in barrier option expires worthless.
Knock-in barrier options are further classified into up-and-in or down-and-in options. In an up-and-in barrier option, the option contract starts only when the price of the underlying asset exceeds the predetermined price barrier. Conversely, if it is a down-and-in barrier option, it turns valid as the underlying asset value drops below the initially set barrier price.
2. Knock-out barrier option
As far as knock-out barrier options are concerned, their validity ceases when the underlying asset hits a barrier during the time horizon of the contract. Knock-out barrier options can also be further decomposed into up-and-out or down-and-out options.
An up-and-out option stops existing when the underlying security moves above the barrier that was set above the initial price of the underlying security.
A down-and-out option stops existing when the underlying security moves below the barrier that was set below the initial price of the underlying security. If an asset underlying the barrier option strikes the barrier anytime during the option’s life, the option is terminated or knocked out.
Examples of Barrier Options
Let us look at two examples of barrier options in action:
Assume an investor is purchasing an up-and-in call option with a strike price of $40 and a barrier price of $50. The current underlying asset’s price is $50. The barrier option will be invalid until the underlying stock exceeds the price level of $65.
The investor pays for the option, which means he will lose money if the barrier option expires worthless. It will expire worthless if the underlying asset’s value will not reach and move above $65 during the life of the option contract.
Now, assume a trader obtained an up-and-out put option. The barrier of the put option is $30, and the strike price is $27. The underlying security is now trading at $23.
The security rises above $30, and thus, the option ceases to exist. It becomes worthless even if it only briefly surpassed the $30 threshold.