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Barrier Options: Summary | Simplified | Comprehensive
Barrier Options - Definition
Barrier Options, also known as Knock-In Options or Knock-Out Options, are exotic options which comes into existence or goes out of existence when certain prices has been reached.
Barrier Options - Introduction
Barrier Options are exactly the same as plain vanilla options except for the fact that it becomes active only after the underlying asset crosses a certain price, known as the barrier. If the underlying asset fails to cross the barrier, the Barrier Options you bought becomes worthless pieces of paper upon expiration even if the underlying asset is trading above it's strike price!
Wait! Doesn't that make Barrier Options more dangerous than normal plain vanilla options? YES! So why would anyone buy Barrier Options? Simply because it carries a much lower extrinsic value than plain vanilla options! If one expects the underlying stock to rally strongly, Barrier Options can result in a higher profitability than plain vanilla options simply because it's cheaper. In fact, Barrier Options get even cheaper when there are not one but two barrier prices!
Barrier Options - Knock-Out Options
The above illustrates how Knock-In Barrier Options work. Knock-Out Barrier Options work the other way round where the barrier terminates the option instead of activating the option. Knock-Out Barrier Options start their life activated, just like any other plain vanilla options, however, if the Knock-Out Barrier Price is reached, the option get terminated and expires worthless.
Again, why would any option trader want to do that? An option trader speculating only a small move in the underlying asset (staying within the strike price and the knock-out barrier price) can maximize profits through the cheaper cost of Knock-Out Barrier Options.
Here is a table summarizing the advantages and disadvantages of Barrier Options versus normal options.
Barrier Options - 4 Types
There are 4 types of Barrier Option features:
:: Up-and-In : Underlying asset needs to move up and beyond barrier price for the barrier option to become active.
:: Up-and-Out : Barrier option becomes de-activated if the underlying asset moves up beyond the barrier price.
:: Down-and-In : Underlying asset needs to move down and beyond barrier price for the barrier option to become active.
:: Down-and-Out : Barrier option becomes de-activated if the underlying asset moves down beyond the barrier price.
The satisfaction of a feature criteria is known as a Barrier Event.
Single barrier options such as the Knock-In and Knock-Out barrier options in the examples above contains only one of the above barrier features. The Knock-In Barrier Option described above is one with a Up-and-In feature. The Knock-Out Barrier Option described above is one with a Up-and-Out feature. It is possible for barrier options to consist of more than one of the above features and is what we call Double Barrier Options. Double Barrier Options have both Up-and-Out as well as Down-and-Out features, forming a barrier around the strike price (hence the name Barrier Options).
Barrier Options - Double Barrier Options
Double Barrier Options or better known as Double Knock-Out Options, have 2 knock-out prices instead of just one, making it an even cheaper alternative than the Single Barrier Options described so far due to the increased probability of terminating the option even when the underlying asset goes the other way.
Again, why would any option trader want to do that? Before you discard this, doesn't this behavior sound exactly like neutral option strategies such as a short straddle where you stand to lose the whole position should the underlying asset rally in either direction? Yes, Double Barrier Options behaves in the same way but at a far far lower premium than neutral option strategies based on normal options, making it an extremely cost effective way to trade a neutral trending asset. Double Barrier Options often also promises a fixed payout in forex trading.
Barrier Options - Other Variations
As if Single and Double Barrier Options are not complex enough, there are many other variations to the Barrier Options. Here are some popular ones:
1. Reverse Barrier Options: Barrier set in the money instead of out of the money.
2. Edokko Options: Complex version of the Barrier Option aimed at preventing a knock out.
3. Parisian Barrier Options: Another complex version of the Barrier Option aimed at preventing a knock out by adding a time requirement to the barrier condition.
4. Partial Time Barrier Options: Barrier Options where barriers are monitored only during specific times.
Barrier Options - Where Is It Traded?
Barrier Options are traded only in OTC markets, which is not easily accessible to the general public through the various stock & options exchanges.
Barrier Options - Pricing
As Barrier options have a fairly long history, there are already a number of established method for pricing Barrier Options. Some popular methods are: Analytical Closed Form, Continuity Correction, Binomial Model, Trinomial Model, Finite Differences and Monte Carlo Simulation. The most popular of these is the Analytical Closed Form developed by Merton, Reiner & Rubinstein in 1973, which is derived from the Black-Scholes model.
Advantages of Barrier Options
1. Cheaper than conventional options
2. Higher resulting profit than conventional options should barrier criterias are satisfied.
Disadvantages of Barrier Options
1. Higher risk of loss due to barrier features.
2. Not publicly traded.