Barrier Options Explained

Barrier Options Explained

A type of exotic derivative option where purchase is determined by a pre-agreed level, barrier options have existed since the 1960s and represent a non-standard (or non-vanilla) way of trading, putting in place additional market requirements before a trade goes ahead.

 

How Barrier Options Work

All barrier options have a set lifetime – this can be very short, for example just a few minutes, or longer, such as several years. An option condition must be set that dictates what the ‘barrier’ or level to be crossed is. There are several different ways a barrier option can be set up:

Barrier

‘Knock-In’ Options:

> Up-and-In

An asset price or share value must rise in price (i.e. go up) to an agreed amount in order for the option to become active (‘in’).

> Down-and-In

The price starts above the agreed barrier and must drop below (i.e. go down) that level in order to become active (‘in’).

‘Knock-Out’ Options:

> Up-and-Out

The option starts as active unless it rises (i.e. goes up) above a certain level, thus becoming inactive (‘out’).

> Down-and-Out

Once an option moves in or out, the move is permanent. If prices/values then dip or rise again, the option is not affected. Double barrier options also exist and involve two knock-out or knock-in values instead of just one. Double barrier options are terminated much more frequently than single barrier options, making them useful for neutral option strategy trades which profit from stagnant markets. Derivation of the price of barrier options is a complex process that goes beyond the accepted Black–Scholes mathematical model.The opposite applies here; the option is active unless it drops down below a certain threshold (going ‘out’).

Binary options are considered to be forms of barrier options. In reality, there are hundreds of different digital, binary and barrier options to trade with; for those looking to understand the subject in great detail, it is necessary to undertake some form of financial education. Forex and the Financial Times are invaluable sources of free market information to help anyone begin to comprehend complex financial terminology.

 

Barrier Options versus Vanilla Options

Vanilla OptionsWhen it comes to making financial trades, barrier options are far less common than traditional vanilla options. Stock or index trades like call options or put options, forms of vanilla options, give the option holder the obligation to buy or sell an asset at a fixed price before a certain deadline.

Exotic barrier options differ because they can become active/inactive in certain market conditions. For example, a barrier option will allow you to purchase or sell an underlying asset based on a price rise or decline. Barrier options are more high-risk than vanilla options because they can become worthless if the barrier is not crossed. However, barrier options can be more lucrative than vanilla options as the gap between the option price and the asset’s intrinsic value is usually much smaller, due to the barrier value.

Where To Trade Barrier Options?

Barrier options are not publically traded; binary options are much more frequently traded via online brokers such as Cedar Finance and 24Option.

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