Barrier option

What is it?

  • A barrier option is a path dependent option that has one of two features:

1. A knockout feature that causes the option to immediately terminate if the underlier reaches a specified barrier level, or

2. A knock-in feature that causes the option to become effective only if the underlier first reaches a specified barrier level.

How is it constructed?

  • They are just simple (OTC) call and put options but with price barriers embedded where the functionality of the option begins or ends.
  • Barrier options are bought and sold in much the same way as OTC vanilla options (there are no listed barrier options).
  •  Premiums are paid in advance and a margin account can be established at the discretion of both parties.
  • Some barrier options offer a rebate if the option hits the barrier.

If barrier not touched:

Payout = MAX [ (ST – X) , 0 ] – C

If barrier touched:

Payout = R-C

Where:

  • ST = stock price at expiry
  • X = strike of call
  • C = price of call
  • R = rebate (if offered by barrier option)

Max profit: (B – X) – C

Max loss: initial cost – any rebate

When is it used?

  • Barrier options were created as a way to provide some of the protection/participation value of an option at a lower premium.
  • For pure option plays, investors widely perceive other derivative products as more profitable and logical to use.
  • However, barrier options form a critical part of a range of structured products and exotic derivatives (e.g. Bonus Certificates, ladder options).

What are the benefits?

  • Lower cost than plain vanilla options (due to risk of knocking out, or never knocking in)
  • A big attraction is the ability to fine-tune the structure to achieve specific yields/participations (see Bonus Certificates)
  • Once the barrier is reached, barrier options have the same benefits as plain vanilla

options:

  1. leverage and potentially higher returns
  2. limited risk (small premium)
  • Barrier options can enable investors to take an aggressive view on skews and e.g. sell volatility at lower strikes than would normally be liquid.

What are the risks?

  • The option is only activated dependant on the barrier requirements. If not, it’s worthless.
  • Hedging of the risk for the option writer can be difficult especially if the option is near the barrier level as it approaches expiry.
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