Barrier options are a type of option where the payoff is contingent on whether the underlying asset reaches a set price barrier. Barrier options are a type of exotic option that is very complex.
The value will fluctuate as the underlying price increases and decreases.
How Do Barrier Options Work?
A barrier option is a derivative option where the payoff depends on the value of the set underlying asset. Therefore, this means the payoff will not come into effect if the underlying asset does not reach a certain price point.
However, barrier options have more features and have different structures from traditional European and American options. Moreover, barrier options can even expire if the underlying asset reaches a certain price which limits the option holder from earning a profit.
What Is a Barrier Option Useful For?
Barrier options can be exercised when the underlying asset passes a specific price point. The most common barrier options include Knock-Out and Knock-In barrier options.
In short, a barrier option is typically useful because they offer cheaper premiums and can be used by investors to hedge their stock positions. Investors use barrier options to increase their returns and gain exposure to add to their portfolio.
What Is an Example of a Barrier Option?
Examples and types of barrier options include knock-out, knock-in, rate-barrier, turbo-warrant, and many others. So, imagine that an investor bought an up-and-in call option that had a strike price of $50 and a barrier of $45, when the underlying stock is trading at $55.
The barrier option would not come into existence until the underlying stock price moved above the barrier which equals $45.
Types of Barrier Options
In short, there are many types of barrier options that investors use to increase their returns on each of their investments.
Knock-Out Barrier Options
Knock-out barrier options typically are up-and-out, or down-and-out barriers. In addition, knock-out barriers become nonexistent when the underlying asset reaches the barrier before it fully matures.
Lastly, knock-out barrier options are a type of barrier option where the value becomes worthless if the knock-out barrier is exceeded.
Knock-In Barrier Options
Knock-in barrier options come into effect when the knock-in price is eclipsed. With knock-in barriers, the set rights connected to the option will only come into effect if the underlying security reaches that set barrier before it reaches its maturity date.
Features of Barrier Options
There are many different features of barrier options that investors can use to their advantage to maximize their potential returns.
Up And In Option
Up-and-in options are a type of knock-out barrier option that gives the option holder the power to exercise once the price level is surpassed or by the underlying asset. Moreover, the investor will be able to benefit from increased prices.
Up And Out Option
Up-and-out options are also a type of knock-out barrier that become nonexistent when the underlying asset reaches the barrier before it fully matures.
Down And In Option
Down-and-in options are knock-in barriers that are based on the barrier price and strike price. In short, they only are visible when the price of the underlying security falls below the set barrier price.
Down And Out Option
Down-and-out options are exotic options that are based on the strike price and barrier price. Lastly with down-and-out options, the payout depends on if the underlying asset reaches the set predetermined price.
Other Types of Barrier Options
Barrier options come in many different forms and serve as excellent investment tools.
Turbo Warrant Barrier Options
With turbo warrant barrier options, the barrier is down-and-out. A turbo warrant is a stock option where the barrier lies in the money.
This type of barrier option has low volatility and are mostly useful for leveraging around Hong Kong, Europe and Germany.
With a Parisian option, if the underlying asset reaches the barrier price it will not trigger anything in the option contract. The underlying assets price must spend a specific time period past the barrier price in order for the contract to come into effect
Buying And Selling Barriers Options
You can only exchange barrier options contracts in over-the-counter markets, not on more commonly available exchanges. Over-the-counter (OTC) markets are more difficult to access for investors.
Benefits & Disadvantages of Barrier Options
There are many benefits and disadvantages of barrier options that investors must be aware of before they begin option trading.
Benefits of Barrier Options
Barrier options are usually cheaper than contracts that do not include a barrier price. This allows investors to have profit more from making correct predictions on the price movement of underlying assets.
Disadvantages Of Barrier Options
Barrier options are more risky than other option contracts. With a knock in contract investors will not profit from the contract if the underlying security has slight movements in price on the market.
Financial Advisors Can Help You Understand Barrier Options
Barrier options are a type of option where the payoff is contingent on whether the underlying asset reaches a set price barrier. There are many types of barrier options that can be used to increase your returns on your investments.
Financial advisors can help you if you feel like you are neglecting your finances and would like to have guidance from an expert. They can teach you about barrier options and work closely with you to manage your finances. They will have your best interest in mind and you will be able to learn how to achieve your financial goals.