What is a Double Barrier Option?

A double barrier option is a derivative applied to currencies or over the counter stocks. Also known as an exotic options, it works as a binary, or digital option in that it pays out only under defined circumstances, or it is worthless, at expiration.

The option uses both upper and lower trigger prices placed on the underlying asset. If the price of the underlying touches or closes beyond either trigger level, called the barriers, then the option either becomes valid or invalid, depending on the specific type (either knock-in or knock-out). In contrast, single barrier options have only an upper or lower barrier, so a move in the opposite direction does not trigger a knock-in or knock out event. Barrier options can be puts or calls.

Key Takeaways

  • This is a type of exotic option traded on currencies or over-the-counter stocks.
  • The execution is based on whether a certain price is exceeded (though not necessarily held) at expiration.
  • Two types of barrier options are typical: knock-in or knock-out. These specify whether the price barrier is beneficial to exceed or not.

How a Double Barrier Option works

Considered an exotic option, a double barrier option is a combination of two single barrier options, with one barrier above and one barrier below the current price of the underlying. It is a bet by the holder that the underlying asset will move significantly, in the case of a knock-in barrier option, or will move by a very small amount, in the case of a knock-out barrier option, over the life of the contract. Traders use these options when they have an opinion on volatility but not on the direction of the underlying asset's next price move. A barrier option is a type of option where the payoff, and the very existence of the option, depends on whether or not the underlying asset reaches a predetermined price.

A knock-in barrier option becomes valid when the underlying exceeds either barrier. It then acts as any other options giving the holder the right but not the obligation to buy the underlying asset at a specific price at or by a specific date.

A knock-out barrier option becomes invalid, or ceases to exist, when the underlying exceeds either barrier.

In contrast, a knock-in option has no value until the underlying reaches a certain price. The critical concept is if the underlying asset reaches the barrier at any time during the option's life, the knock-in option is brought into active existence and will remain that way until expiration. It does not matter if the underlying moves back to pre-knock-in levels.

Other Types of Barrier Options

Barrier options come in single and double barrier varieties, as covered above. Single barrier options come in four varieties: down-and-in, down-and-out, up-and-in, and up-and-out, covering all possibilities of single barrier and the knocking feature.

However, there are several others, including binary options, which pay a set amount if a barrier is reached or zero if it is not reached.

Using Barrier Options

Large institutions or market makers create these options by direct agreement for the primary reason that valuing them is a complex undertaking. For example, a portfolio manager can use them as a less expensive method to hedge against losses on a long position. The hedge would be less costly than buying vanilla put options. However, it would be imperfect since the buyer would be unprotected if the security price decreased below the barrier price.

Pricing depends on all regular options metrics with the knock-in or knock-out features adding an extra dimension. European style expiration, where the exercise may only happen at the expiration date, are complicated enough. However, an American style option, where the holder may exercise the option at any time on or before expiration, is even more complicated.