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.

RELATED TERMS
  1. Knock-In Option

    A latent option contract that begins to function as a normal ...
  2. Up-and-In Option

    Up and in options are a type of barrier option that can only ...
  3. Rebate Barrier Option

    A rebate barrier option is a barrier option that includes a rebate ...
  4. Down-and-Out Option

    A down-and-out option is a type of knock-out barrier option that ...
  5. Double One-Touch Option

    A type of exotic option that gives an investor an agreed upon ...
  6. Barriers To Entry

    The existence of high start-up costs or other obstacles that ...
Related Articles
  1. Trading

    Getting acquainted with options trading

    Learn about trading stock options, including some basic options trading terminology.
  2. Trading

    Options Hazards That Can Bruise Your Portfolio

    Learn the top three risks and how they can affect you on either side of an options trade.
  3. Trading

    Options Pricing

    Options are valued in a variety of different ways. Learn about how options are priced with this tutorial.
  4. Trading

    Getting Started In Forex Options

    Stocks are not the only securities underlying options. Learn how to use FOREX options for profit and hedging.
RELATED FAQS
  1. Regular Vs. Exotic Options: What's the Difference?

    Before learning about exotic options, you need a fairly good understanding of regular options. Read Answer >>
  2. How do I change my strike price once the trade has been placed already?

    Learn how the strike prices for call and put options work, and understand how different types of options can be exercised ... Read Answer >>
  3. When is a put option considered to be "in the money"?

    Learn about put options, what they are, how these financial derivatives operate and when put options are considered to be ... Read Answer >>
Hot Definitions
  1. Economies of Scale

    Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
  2. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  3. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  4. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
  5. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  6. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
Trading Center