Barrier options come under the category of exotic options. They are similar to regular option contracts. Barrier options have an important feature which is absent in other option types. This additional feature is the barrier. The barrier is a fixed price. In barrier, the contract is either activated or terminated. Barrier options are particularly common in forex.
Barrier options also come in different types. They exist in two types, European style and American type, although European is mostly used. Basic types are also calls and puts.
To make barrier options simple, we have provided the details of how they work, advantages of barrier options and also how you can buy and sell these contracts.
Knock-In and Knock-Out
Barrier options are classified as either knock in or knock out.
A knock-in price is initially inactive. It becomes active when the underlying stock reaches a predetermined price. This price is specified in the contract.
A knout-out price starts out being active. It gets automatically cancelled once the price reaches a predetermined price. This price is known as the knock out price. If the knock- out price gets cancelled, it becomes worthless. It cannot be reactivated even if the stock price reverses back.
There are two types of knock-in contracts and knock out contracts. Knock ins are classified as up-and-in or down-and-in. Knock-outs are classified as up-and-out or down-and-out. We will see each of these in the upcoming paragraphs.
Up and In
An up and in barrier options contract starts in the sleeping mode. The knock-in price in ‘up and in’ contract is above the current price of the underlying stock. It becomes active if the stock price moves above the knock-in price. If the stock price could not reach the knock-in price before the expiration, then the contract expires without any value.
Down and In
A down and in barrier option also starts in the sleeping mode. The knock-in price is set below the current market price of the underlying stock. The contract is activated once the security falls below the knock-in price. Here also, if the stock does not reach the ‘knock-in’ price by expiration, then the contract expires worthless.
Such contracts are usually cash-settled. Which means you need not physically buy the underlying stock and then sell to make a profit. As you will receive your profits in cash. You may also sell your contracts at any time before the expiration if you find profit.
Up and Out
An up and out option contract is a type of ‘knock-out’ contract. It starts out being active. Anytime before the expiration, if the stock moves above the specified ‘knock-out’ price, then the contract automatically expires. Once the knock out is reached the contract is terminated permanently. You need to exit compulsorily.
Down and Out
A down and out is another type of knock-out option. This option also starts being active. In a down and out option contract, the knock-out price is below the current market price of the stock. If the stock falls below the ‘knock-out’ price at any point before the expiration, the contract again expires automatically.
Double Barrier options
Double barrier options are another type of knock out option contract. They are also known as double knock-outs. They are a combination of ‘up and out’ contract and the ‘down and out’ contract. They have two ‘knock out’ prices.
The first is the price that is above the price of the underlying stock. The second one is the price that is below the stock price.
Therefore, a double barrier contract can be exercised if the stock moves significantly in either direction. This increases the risk for the option buyer as the chances of a contract expiring worthless are high.
Advantages and Risks of Barrier options
- Barrier options carry a higher risk than the usual option contracts. For a buyer of knock-in contract to be in profit, the price of the stock needs to move by a certain amount. Then only he can exercise his option. This means if the stock moves by just a few pips, there won’t be any profits.
- However, there is one significant advantage that barrier options provide, which is not provided by regular options. Since the risk is higher here, the barrier options are generally cheaper. This increases our profitability. The returns would be more on our investments. But this only happens if we are correctly able to predict the price of the underlying stock.
- Double barrier options are riskier than normal barrier options because price movement in either direction can result in options expiring worthless.
- Therefore, you need to go the rule which says, if you are expecting large price movement in stock then you should choose ‘knock-in’ contract. Whereas, if you are expecting a small price movement, then you should choose knout out contracts.
How to buy and sell Barrier options
Barrier options are mostly traded in over the counter (OTC) markets. They are not regulated by accessible exchanges. Not many brokers have access to OTC trading system. Hence, OTC markets are not easy to access as they are not traded on the public exchanges. However, today, some brokers are slowly providing them.
That’s about Barrier options. Hope you found your reading worthwhile. Watch this space for more education.