What is a barrier option?
A barrier option is a financial option whose value development depends on whether or not a predetermined level – the barrier – of the underlying asset is reached. If this level is hit, the option can become active (so-called “knock-in option”) or the option can be canceled (so-called “knock-out option”).
The advantage of barrier options compared to standard options is that the conditions lower the price of the option than with normal options. The barrier options are among the basic building blocks of exotic options. Other exotic options are often composed of different barrier options. The well-known click funds are also constructed in this way.
Main types of barrier options
The barrier options are similar to normal options, except that the value development depends on reaching a certain level. If a certain level (the trigger) is hit, the option will lapse or the option will be activated correctly.
- Knock in options
The option is only activated when a certain level is hit. Until then, the option is worthless.
Example: The ING 34 call knock in 26 . The option only becomes active when the share price falls to 26 euros, and ultimately yields net asset value if it expands above 34 euros.
- Knockout options
The option is already activated and acts as a normal option. The option will lapse if the knockout level is hit.
Example: The ING 34 call knock out 38 . As the share rises above 34 euros, the option becomes more and more worthwhile, until the 38 euros is touched and the option is finally canceled.
Normal barrier options depend on reaching certain price levels during the term of the option. There are also two important variants of this.
Discrete barrier option: At predetermined times it is checked whether price levels have been reached, outside these periods it does not matter.
Parisian barrier option: reaching the barrier is not enough, the underlying value must also remain a fixed period on this wrong side of the barrier.