A LOOK INTO BARRIER OPTIONS
- May 12, 2017
- 3 min read
In investment, a barrier option is an exotic option on an underlying asset whose existence depends upon the underlying asset's price reaching pre-set barrier level: the derivative either springs into existence or, if the option already exists, it is extinguished.
Where the option springs into existence upon the underlying asset's price reaching the barrier level, it may be called an up and in, knock-in, or down and in option.
Where the option is extinguished upon the underlying asset's price reaching the barrier level, it may be called an up and out, knock-out, or down and outoption.
A barrier option has a lower premium than a similar option without a barrier. Barrier options were created to provide the hedge of an option at a lower premium than a conventional option.
Now what does all this mumbo jumbo mean? Lets take an example - Suppose we have a call option (i.e a right to buy) on a stock whose current market price is Rs.150. The call has a strike price of 175 - but there is a catch - the call will come alive if the price of the stock goes above Rs. 200.And wait there is another catch - the option will die out if the stock price goes above Rs.250. It essentially means that you are betting that the stock price will be above Rs. 200 but below Rs.250. In such a case if the price ever goes beyond Rs.250 the option contract becomes null and void and will not be reactivated even if the price subsequently goes below Rs.250. In other words, once knocked out, the option can never revive.
Barrier Options are exactly the same as plain vanilla options except for the fact that it becomes active only after the underlying asset crosses a certain price, known as the barrier. If the underlying asset fails to cross the barrier, the Barrier Options you bought becomes worthless pieces of paper upon expiration even if the underlying asset is trading above its strike price!
Types of barrier options
The two most common types of barrier options are knock-in and knock-out barrier options.
Knock-In barrier options
With this type of barrier option, the option only comes into life if the knock-in price is exceeded. It can therefore expire worthless even if it is trading beyond the strike price at expiration.
Example:
Shares of company ABC are currently trading at Rs.100. A trader buys knock-in barrier call options on these shares with a strike price of Rs 110 and a knock-in barrier of Rs.120. At expiration date the shares are trading at Rs.115. The options expire worthless, since although the strike price has been exceeded, the underlying price never traded above the knock-in barrier of Rs120.
Knock-out Barrier Options
This type of barrier option becomes worthless if the knock-out barrier is exceeded.
Example:
Shares of company ABC are currently trading at Rs.100. A trader buys knock-in barrier call options on these shares with a strike price of Rs.110 and a knock-out barrier of Rs.120. At expiration the shares are trading at Rs.125. Once again the options expire worthless, since although the underlying share price is above the strike price, the options became worthless the moment the share price crossed Rs.120.
Valuing these kind of options is always a tricky affair because one needs to consider not only the current price at which the stock is trading but also needs to consider the path that the stock is likely to take and the probability of such path being taken
This was just an introduction to Barrier option. We will be looking at other intricate aspects like valuation etc in future blogs....
Cheers !!!
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