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
- 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
- leverage and potentially higher returns
- 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.