A barrier option is a type of financial derivative that is a variation of a standard option contract. It gives the holder the right, but not the obligation, to buy (call option) or sell (put option) a specified underlying asset at a predetermined price (the strike price) if the price of the underlying asset reaches a certain level (the barrier) during the option’s lifetime.
There are two main types of barrier options:
Knock-In Option: This option comes into existence (becomes “active”) only if the price of the underlying asset reaches the barrier level. Once the barrier is hit, it functions like a regular option.
Knock-In Call Option: Allows the holder to buy the underlying asset if the barrier is reached.
Knock-In Put Option: Allows the holder to sell the underlying asset if the barrier is reached.
Knock-Out Option: This option ceases to exist (becomes “knocked out”) if the price of the underlying asset reaches the barrier level. Once the barrier is hit, the option becomes worthless and expires.
Knock-Out Call Option: Allows the holder to buy the underlying asset unless the barrier is reached.
Knock-Out Put Option: Allows the holder to sell the underlying asset unless the barrier is reached.
Barrier options are used by investors and traders to manage risk in various ways. For example, they can be employed to hedge against price movements or to speculate on market volatility. They are particularly useful in markets where prices may experience rapid and unpredictable changes.
It’s important to note that barrier options are more complex and typically more expensive than standard options because they have additional features and contingencies. They are also valued based on a variety of factors including the current price of the underlying asset, the barrier level, time until expiration, and market volatility.
Additionally, barrier options can have different variations, such as up-and-out or down-and-out, which refer to whether the barrier is set above or below the current price of the underlying asset. These variations can significantly affect the pricing and behaviour of the option.