Barrier options and their types
Barrier options are a form of non-traditional derivatives that are most commonly used in the over-the-counter market. These instruments begin or end when the underlying asset has reached a certain level of value. A start or cancellation condition called a barrier is triggered in this case. Traditional derivatives do not have this additional parameter. Here, the implementation takes place after the asset reaches the strike price.
There are two basic types of barrier options:
– Knock-out – the option is inactive when the underlying asset’s value has reached a certain level. If this threshold is not reached, the option is considered standard.
– Knock-in – the option can only be exercised when the value reaches a certain level. Before this threshold, the option is worthless.
In turn, these instruments have several varieties. For example, the knock-out action is terminated if the spot price exceeds the previously set value. Such a variation is called an up-and-out. If the spot price falls to a level below the previously recorded value, the knock-out is also not performed, but up-and-in occurs.
A variation of the knock-out is the down-and-in, which indicates the start of the option when the price falls to a level fixed below its original value. For example, if the stock’s spot price is 40 and the barrier is 45, the price rises to 50. If the knock-out and knock-in are active, then the knock-out is no longer active at the up-and-out. Knock-out execution begins as the up-and-in option is observed. And any of the marked derivatives can be calls and puts. Regarding maturity, European options of this type are the most popular. However, American and Bermuda options may be in effect.
The premium for this type of option is lower than standard options due to the execution complexity. In addition, such derivatives are considered less risky for sellers and, therefore, need to be more profitable from a buyer’s perspective. For example, in July, the spot price of shares was 200 dollars and kept growing. Meanwhile, the market offers regular and knock-out call options for September at the same price of $205. The condition for the knock-out specifies a price barrier of $210. If, in August, the price goes up to 220 dollars, the owner of the option can count on the profit in the ratio of 220 – premium – 205, and the yield is not limited. If the share price passes the barrier, the knock-out carries no profit, and the seller receives a premium. When working with barrier options, the risk is borne by the asset’s value; in addition, this type of derivative limits the profit of its owner.
