What is a 'Barrier Option'
A barrier option is a type of option whose payoff depends on whether or not the underlying asset has reached or exceeded a predetermined price. A barrier option can be a knock-out, meaning it can expire worthless if the underlying exceeds a certain price, limiting profits for the holder but limiting losses for the writer. It can also be a knock-in, meaning it has no value until the underlying reaches a certain price.
BREAKING DOWN 'Barrier Option'
Barrier options are considered a type of exotic option because they are more complex than basic American or European options. Barrier options are also considered a type of path-dependent option because their value fluctuates as the underlying's value changes during the option's contract term. In other words, a barrier option's payoff is based on the underlying asset's price path. Barrier options are typically classified as either knock-in or knock-out.
Knock-In Barrier Options
A knock-In option is a type of barrier option that only comes into existence when the price of the underlying security reaches a specified barrier at any point in time during the option's life. Once a barrier is knocked in, or comes into existence, the option will not cease to exist until the option expires.
Knock-in options may be classified as up-and-in or down-and-in. In an up-and-in barrier option, the option only comes into existence if the price of the underlying asset rises above the pre-specified barrier, which is set above the initial asset price. Conversely, a down-and-in barrier option only comes into existence when the underlying asset price moves below a pre-determined barrier that is set below the initial asset price.
For example, assume an investor purchases a up-and-in call option with a strike price of $60 and a barrier of $65, when the underlying stock was trading at $55. Therefore, the option would not come into existence until the underlying stock price moved above $65.
Knock-Out Barrier Options
Contrary to knock-in barrier options, knock-out barrier options cease to exist if the underlying asset reaches a barrier during the life of the option. Knock-out barrier options may be classified as up-and-out or down-and-out. An up-and-out option ceases to exist when the underlying security moves above a barrier that is set above the initial security price, while a down-and-out option ceases to exist when the underlying asset moves below a barrier that is set below the initial asset price. If an underlying asset reaches the barrier at any time during the option's life, the option is knocked out, or terminated, and will come back into existence.
For example, assume a trader purchases an up-and-out put option with a barrier of $25 and a strike price of $20, when the underlying security was trading at $18. The underlying security rises above $25 during the life of the option, and therefore, the option ceases to exist.