A barrier option is a path dependent option that has one of two features:
- A knockout feature causes the option to immediately terminate if the underlier reaches a specified barrier level, or
- A knock-in feature causes the option to become effective only if the underlier first reaches a specified barrier level.
Premiums are paid in advance. Due to their contingent nature, barrier options have lower premiums than corresponding vanilla option.
Consider a knock-in call option with a strike price of EUR 100 and a knock-in barrier at EUR 110. Suppose the option was purchased when the underlier was at EUR 90. If the option expired with the underlier at EUR 103, but the underlier never reached the barrier level of EUR 110 during the life of the option, the option would expire worthless. On the other hand, if the underlier first rose to the EUR 110 barrier, this would cause the option to knock-in. It would then be worth EUR 3 when it expired with the underlier at EUR103. This is illustrated in Exhibit 1:
The particular option in this example is known as an “up-and-in” option because the underlier must first go “up” to the barrier before the option knocks “in.”
In all, there are eight flavors of barrier options comprising European puts or calls having barriers that are:
- up-and-out, or
Of the eight, four either knock-in or knockout when they are in-the-money. These are called reverse barrier options. They can pose significant hedging challenges for the issuer.
Alternative structures include multiple barriers or barriers incorporated into other types of derivatives. For example, binary options can be structured with barriers.