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Published On: Tue, Nov 27th, 2012

Barrier Options Explained

Barrier options are similar to standard stock options, although there are vital differences.

Where a standard call option or put option have a payoff that only depends on whether the
strike price has been exceeded or not, a barrier option’s payoff depends on two price levels:
the strike price and the so-called barrier price.

Investors use barrier options to enhance returns from or gain exposure to future market
scenarios that are more complicated that the simple bearish or bullish expectations that form
part of an ordinary vanilla option.

Books can (and have been) written about barrier options, so this is only intended as an
introduction to the subject.

Types of barrier options

The two most common types of barrier options are knock-in and knock-out barrier options.

Knock-In barrier options

With this type of barrier option, the option only comes into life if the knock-in price is
exceeded. It can therefore expire worthless even if it is trading beyond the strike price at
expiration.

Example:

Shares of company ABC are currently trading at $100. A trader buys knock-in barrier
call options on these shares with a strike price of $110 and a knock-in barrier of $120. At
expiration date the shares are trading at $115. The options expire worthless, since although
the strike price has been exceeded, the underlying price never traded above the knock-in
barrier of $120.

Knock-out Barrier Options

This type of barrier option becomes worthless if the knock-out barrier is exceeded.

Example:

Shares of company ABC are currently trading at $100. A trader buys knock-in barrier call
options on these shares with a strike price of $110 and a knock-out barrier of $120. At
expiration the shares are trading at $125. Once again the options expire worthless, since
although the underlying share price is above the strike price, the options became worthless
the moment the share price crossed $120.

More types of barrier options

The two types of barrier options described above are up-and-in (first example) and up-and-out
(second example). Their put counterparts are found in the so-called down-and-in and down-
and-out put barrier options.

A down-and-in barrier option only becomes activated when the underlying price crosses the
barrier price, similar to the first example above, with the difference that here the strike price
and barrier price are both below the current price of the underlying asset.

A down-and-out barrier option becomes worthless the moment the price of the underlying
asset trades below the barrier price. This is similar to the second example above, with the
difference that the option only loses its value if the price of the underling starts trading below
the barrier price.

Benefits and disadvantages of barrier options

Barrier Options are used by professional traders because:

a) They are generally speaking cheaper than conventional vanilla options and
b) They therefore allow for a bigger percentage profit on the investment if the trade
works out

Disadvantages of barrier options

The biggest single disadvantage of barrier options is that, because more conditions have to
be met before the option expires In The Money, the probability of loss is bigger than with an
ordinary vanilla option.

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About the Author

- Marcus Holland has been trading the financial markets since 2007 with a particular focus on soft commodities. He graduated in 2004 from the University of Plymouth with a BA (Hons) in Business and Finance.

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