What is a Barrier Option?
Most options traders rely on standard calls and puts. Those seeking more optionality might branch into European options. But even beyond these options, there’s a world of opportunity in the realm of derivatives. Those seeking to embrace risk—and the reward that comes with it—gravitate to barrier options.
Barrier options are a group of exotic stock options. They’re governed by different rules than standard options, and have more variables to consider. If you’re a math-oriented trader, barrier options also present more of a challenge in calculating payoff—you’ll need to get familiar with binomial trees!
If you’re an experienced trader looking to dabble in more complex options, here’s what you should know about barrier options.
A Closer Look at Barrier Options
Traders refer to barrier options by the type of option they’re buying and the expected performance that will land them in the money. These are “knock in” and “knock out” options:
These options come into existence once a stock price passes the barrier threshold. It remains in existence so long as the option remains open. For example, if a trader buys a $55 knock-in option for ABC Company with a strike price of $50, the trader can’t exercise that option until the price breaks the $55 threshold. Knock-in options are bullish options.
These options start out real, but cease to exist of the stock price of a security crosses the barrier threshold. It remains in existence so long as it doesn’t cross the price. For example, if a trader buys a $55 knock-out option for ABC Company with a strike price of $50, that option is exercisable until the price breaks the $55 threshold. Knock-out options are bearish.
There are also KIKO options, which include both knock-in and knock-out barriers.
As you might imagine, knock-out options tend to be less expensive than knock-in options, since they’re a known quantity at the point they’re issued. Conversely, knock-in options can be more lucrative, since they cease to exist until the stock price crosses the barrier.
Outcomes Associated with Barrier Options
There are four outcomes for barrier options, which depend on the nature of the option. Again, this relies on whether you’ve purchased a knock-in or knock-out option. Here’s how to land in the money.
- Up and out. Bearish traders make money on a knock-out option that stays below the barrier price. If the price exceeds the threshold set on a knock-out option, it becomes “up and out” of the money, ceasing to exist.
- Up and in. If the stock price increases above the level of a knock-in option, that option becomes real. The trader is “up and in” the money, so long as the price remains above the barrier at the time of expiration (exercise).
- Down and out. Bullish traders make money on a knock-out option that stays above the barrier price. If the price falls below the threshold set on a knock-out option, it becomes “down and out” of the money, ceasing to exist.
- Down and in. If the stock price decreases below the level of a knock-in option, that option becomes real. The trader is “down and in” the money, so long as the price remains below the barrier at the time of expiration (exercise).
The key in each of these outcomes is the barrier. Where traditional call and put options are price-dependent, barrier options are range-dependent. The barrier marks the validity of the option, while the stock price represents its potential ROI. As such, these options carry more risk and complexity when compared to American and European options.
Provisions to Consider
There are additional provisions that can change the behavior of a barrier option, making them even more complicated. Here’s a look at some of the ways traders can both hedge risk and increase reward using barrier option provisions:
- Rebates. Some barrier options come with rebates to make them more enticing to investors. These are options that either cost more or carry more risk, but are offset with a rebate to protect traders. Rebates are a percentage of the option’s premium that’s paid to the buyer even if the option expires worthless.
- Parisians. This provision specifies an amount of time that the underlying stock price needs to remain beyond the barrier for the option to become valid. For example, the barrier for a knock-in option might be $55, with a Parisian provision of two days. For the option to become valid, the stock price needs to stay above $55 for two days.
- Turbo warrants. Popular in Hong Kong, turbo warrants are a specific type of down-and-out provision The strike price is the same as the barrier. Turbo warrants are highly leveraged, yet benefit from capped risk due to the correlated strike and barrier prices.
Provisions tend to add to the already complex nature of barrier options. As a result, they’re usually reserved for highly speculative investors and those with a deep understanding of derivatives.
Complex, But Lucrative Options
All the complexity and risk of barrier options boils down to tremendous ROI opportunity for investors. Those who can factor in barriers and provisions successfully stand to benefit tremendously from accurate predictions of security price behaviors. Moreover, they’re also a good way to hedge risk in a portfolio filled with aggressive securities.
Always remember that when it comes to barrier options, the barrier represents a criterion for execution. It doesn’t matter what your strike price is if the option doesn’t meet the criteria associated with a knock-in or knock-out barrier.