Barrier Option

Barrier options are option contracts that remain inactive until a certain "barrier price" is achieved. The call or put option is activated on reaching the barrier price point. A long or short options position is created. There is a provision to exercise the option position automatically. The purpose of using barrier options is to provide investors with a customizable way to manage risk and potentially enhance returns in their investment portfolios.

They are also path-dependent options since they have a value that changes throughout the contract according to the value of the underlying assets. This arrangement limits profits if the prices are bullish and has low barrier price. At the opposite end of the spectrum, setting a barrier for a price can limit losses when asset prices rise.

• Barrier options are derivative contracts triggered or terminated when the underlying asset price reaches a specific threshold. This provision offers increased leverage or protection.
• They are further subdivided into Up-and-out, Down-and-out, Up-and-in, and Down-and-in barrier contracts.
• Barrier contracts combine characteristics of regular options with additional bets. First, they bet whether the underlying asset price will reach the barrier. By doing so, the investor takes a greater risk; any fluctuation in the underlying asset can cause hefty losses.

A barrier option is a derivative contract that is activated (knocked in) or extinguished (knocked out) when the asset price reaches a barrier. The underlying asset may be a stock, index, or exchange-traded fund. These options are less expensive than their plain-vanilla counterparts. Thus, costs associated with risk exposure are modified.

Before venturing further, let us quickly define options. Options are contracts that allow the buyer a right, but not an obligation, to buy or sell an asset on a specific date at a particular price, called the strike price. The strike price is predetermined at the time of purchase. Simply put, the buyer can exercise the contract if they think it will benefit them. Conversely, they will not undertake the transaction if they think it will result in losses.

Barrier contracts help investors curtail hedging expenses. It is ideal for traders undertaking directional bets and investors, allowing residual risk on the books. In addition, barrier contracts allow market participants to customize trading strategies according to their market viewpoints.

The barrier option is a derivative instrument that derives value from underlying assets. To calculate the option value, traders rely on the current spot rate, strike rate, forward rates, barrier strike rate, barrier type, volatility, tenor, and interest rate differentials.

A bought call or put option with a barrier aids the buyer in hedging risks associated with foreign currency payables and receivables. In addition, it protects the investor when the exchange rate surpasses the bought call or put option strike rate (provided the option does not knock out).

Barrier contracts can be purchased only from over-the-counter markets. It cannot be bought from the more accessible stock exchanges.

The termination value of a barrier contract would depend on various rates—spot rate, volatility, tenor, discount factors, and interest rates. Any lack of market liquidity for the currency could result in a greater bid-offer spread. This would hurt the market value of the outstanding derivative contract.

Currency markets are extremely volatile. The prices of the underlying currencies fluctuate suddenly and deviate over a wide range. The volatility is caused by unforeseen circumstances or alterations in the currency markets. As a result, when the barrier contract is terminated, profit or loss depends on changes in the underlying currencies.

Let us look at the following barrier option graph to get a better idea regarding the concept.

With help from the above graph, one can understand that the option does not exist any longer if the price gets to the knockout barrier. Hence, its value continues to be 0 even if the underlying asset’s price moves back within that barrier prior to the date of expiry mentioned in the contract. 

Let us look at barrier option types.

#1 Knock-In

Knock-in options are futile unless the asset price exceeds the predetermined threshold. The asset price loses its value as soon as it crosses the barrier.

In other words, they can be exercised when the underlying asset price crosses the predetermined barrier level. But, if the price never touches the barrier level, this options contract is irrelevant.

For an investor who thinks the spot will touch the out-strike price within the investment period, the leverage impact of a KI option might be far more appealing than the leverage of a regular option (non-barrier). Thus, investors benefit more from the added risk of the asset not knocking in.

#2 Knock-Out

Knock-out options or KO options lose their utility if the underlying spot crosses the predetermined barrier. If that does occur, the option holder gets a KO coupon.

This feature can be added to contract specifications. Investors who think that the spot won't reach the outstrike find the leverage effect of a KO option significantly more alluring than a regular options contract. They generate higher profits by taking the added risk of a spot not knocking out.

Now, let us look at a barrier option example to understand it better.

David wants to trade, the exercise price is $100, and the barrier price is $150. Therefore, the call option will not be exercised if the stock price remains below $150. However, if the stock price exceeds the barrier price of $150, David can exercise the call option at $100.

Now, let us look at barrier option hedging.

Hedgers in the financial markets find exotic barrier options appealing; typically, barrier contracts cost less. However, barrier contracts are challenging to hedge; they combine characteristics of regular options with a bet on whether the underlying asset price will reach the barrier. As a result, the option price is even more sensitive to fluctuation in underlying asset prices.

Due to the discontinuity barrier, contract hedging is challenging, particularly up-and-out calls and down-and-out puts. In addition, Delta, Gamma, and Vega are positive for regular options and negative under near-barrier circumstances. When banks attempt hedging solutions, they face real-world constraints—transaction costs, discrete trading, and liquidity issues.

This has been a guide to what is Barrier Option. Here we explain the concept in detail with its example, hedging, and types. You can learn more about it from the following articles –

• Ladder Option
• Exotic Option
• Over-Hedging