Barrier Options
A barrier option is a type of derivative where the payoff depends on whether or not the underlying asset has reached the predetermined price.
What is a Barrier Option:
A barrier option is a type of Exotic option where if the underlying asset has reached or exceeded a predetermined price payoff is made. A barrier option can go knock-off which means it expires worthless if the underlying asset does not exceed a certain price
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Barrier options are considered Exotic Options as they are more complex than American & European Options the value of Barrier options fluctuates as the value of underlying asset changes so they are considered as a type of path-dependent option. The option may turn worthless or may be activated upon the crossing of a price point barrier. Barrier options are typically classified into Knock-In & Knock-Out.
How does it work?
A barrier option is considered an exotic option as it comes with more features than regular American & European options. Barrier options are also referred to as path-dependent options since their value fluctuates along with the value of the underlying assets. The option can be exercised when the price of the underlying asset crosses a predetermined price point barrier.
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Types of Barrier Option:
- Down-and-out Call:- it is a standard call option that knock-outs if the underlying asset price hits the barrier level, which is set below the current value
- Down-and-out Put:- it is a standard put option that knock-outs if the underlying asset price hits the barrier level, which is set below the current value
- Down-and-in Call:- it is a standard call option that only comes into existence if the underlying asset price hits the barrier level, which Is set below the current value.
- Down-and-in Put:- it is a standard put option that only comes into existence if the underlying asset price hits the barrier level, which Is set below the current value.
- Up-and-out Call:- it is a standard call option that ceases to exist if the underlying asset price hits a barrier level, which is set above the current stock.
- Up-and-out Put:- it is a standard put option that ceases to exist if the underlying asset price hits a barrier level, which is set above the current stock
- Up-and-in Call:- it is a standard call option that only comes into existence if the underlying asset price hits the above current price of the stock.
- Up-and-in Put:- it is a standard put option that only comes into existence if the underlying asset price hits the above current price of the stock
How to trade Barrier options:
A barrier event occurs when the underlying crosses the barrier level, while it seems straightforward to define a barrier event as “underlying trades at or above a given level,” in reality, it’s not so simple. What if the underlying only trades at the level for a single trade? How big would that trade have to be? When barrier options were first introduced to the options market, many banks had legal trouble resulting from mismatched understanding with their counterparties regarding exactly what constituted a barrier event.
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Final thoughts:
Hence barrier option is a good Exotic Options that can be chosen by hedgers for taking offsetting positions and reduce their risk in the portfolio and also good for traders to reduce their losses in case of wrong calculations and analysis.
Author – Hariharan Krishnan
About the Author – Hariharan Krishnan is currently in second year BAF and is also doing FRM part 1. He is passionate about financial markets and loves to play chess and outdoor games.
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