Barrier options are complex derivative products that have payoffs based on whether an underlying asset crosses a pre-specified price threshold.
There are several types of barrier options, and they are used to hedge a portfolio or simply to speculate on an underlying asset’s price change, much like regular call and put options. But due to the restriction of the barrier, premiums tend to be lower when initiating the trade.
What Is a Barrier Option?
Barrier options are just like regular options with the inclusion of an additional barrier to the regular option payoff.
Beginners start trading options with purchases of simple puts and calls. Options trading quickly turns complex as you dive into writing options, combination strategies, and exotic options.
In contrast to barrier options, plain-vanilla options typically have some value as the asset approaches and then crosses the strike price. Before an option is in the money, the value is known as time or extrinsic value.
Once an option is in the money, the option price is a combination of intrinsic value and extrinsic value.
A barrier option’s payoff (or lack thereof) is predicated by the underlying asset crossing some barrier price determined upon option initiation. Once the barrier is crossed, the nature of the option changes.
In some cases, the option is “normal” but after crossing the barrier it becomes worthless forever, simply by crossing the barrier. Other barrier options begin as worthless (or close to it), but revert to a normal option once they cross the barrier, even if they later cross the barrier again.
These products can be used to develop simple or complex strategies in options trading.
💡 Quick Tip: If you’re an experienced investor and bullish about a stock, purchasing call options (rather than the stock itself) can allow you to take the same position, with less cash outlay. It is possible to lose money trading options, if the price moves against you.
How Barrier Options Work
First, recognize that a barrier option is an exotic option — it comes with added rules and features compared to the more common American-style and European-style flavors. A barrier option is also path-dependent, much like non-exotic options, in that its value is determined by changes in the underlying asset’s market price.
A key feature of a barrier option is when it can be exercised. Depending on the barrier option pricing terms, its value activates or becomes worthless at that crossover price.
Pros and Cons of Barrier Options
Barrier options work like puts and calls, but they feature more restrictions than standard American or European options. That leads to advantages and disadvantages for both the holder and seller of a barrier option.
Barrier options’ pricing terms often dictate how and when traders of these derivatives might use them in their trading strategies.
In general, there is less risk for the barrier option seller and more restrictions put on the owner. Both parties, however, should be aware that there is less liquidity in barrier option markets compared to more actively traded standard options markets.
| Pros | Cons |
|---|---|
| Lower option premiums means a cheaper way to trade for option buyers | Less chance to exercise due to restrictive terms (for the holder) |
| Reduced risk to the option writer | Poor liquidity versus plain vanilla puts and calls |
| Can be more customized than standard options | Added complexity makes barrier options tougher to understand for new traders |
Finally, user-friendly options trading is here.*
Trade options with SoFi Invest on an easy-to-use, intuitively designed online platform.
*Check out the OCC Options Disclosure Document.
Knock-In and Knock-Out Barrier Options
Knock-in and knock-out barrier options are the two common types of barrier options. Knock-in options are unable to be exercised until the underlying security crosses a trigger point, deemed the barrier price.
Knock-out options can be exercised immediately, but they turn inactive (worthless) at the time of breaching the barrier price. It can be helpful to see how these products work via barrier options examples.
Knock-In
Knock-In Option Example
Let’s say you buy a knock-in barrier call option featuring a strike price of $100 and a barrier of $110 while the underlying security trades at $90. The option is not exercisable until the underlying asset’s price climbs above the $110 barrier.
The option owner pays a premium but that premium is lower than for a regular call. Why?
Two reasons:
1. The barrier option won’t be immediately exercisable and is worth close to zero until the underlying asset crosses the barrier price.
2. The barrier price typically exceeds the strike price for calls and is below the strike price for puts. That means the likelihood to have any intrinsic value is lower because the option must first breach the barrier. A regular option has intrinsic value once it exceeds the strike price.
However, after the barrier is breached the barrier option will trade like any other standard call option with a strike of $100, no matter what the price does subsequent to breaching the barrier. If the barrier is not broken, the seller keeps the premium.
Knock-in barrier options are broken down further into up-and-in or down-and-in options.
The call above is an up-and-in barrier option example, the asset price must move up for the option to be exercisable. Down-and-in means the price must move down to the barrier before it is exercisable and typically is used for barrier put options.
Knock-Out
Knock-Out Option Example
For a knock-out barrier option, we’ll assume you bought an up-and-out call option with a barrier of $50 and a strike of $40 while the underlying asset trades at $35. If the asset rallies to $50, the option will cease to exist and be worth nothing.
A knock-out option is worthless even if the underlying asset’s price touches the barrier price for only a moment before falling back.
The call above is immediately exercisable and will always trade at a lower price than a regular call. Why?
Reasons include:
1. If the underlying asset is far from the barrier, the option will be cheaper than a regular option as it is still at some small risk of breaching the barrier and being worthless.
2. As the underlying asset moves closer to the barrier the option will move towards zero as the risk of crossing the barrier increases dramatically.
Knock-out barrier options are broken down further into up-and-out or down-and-out options. The difference is which way the price must move to breach the barrier and become worthless.
As you can see, barrier options pricing puts a spin on the usual calls and puts you might be familiar with.
Types of Barrier Options
Beyond knock-in and knock-out options, there are a few other barrier option types to learn about.
Rebate Barrier Options
Rebate barrier options have provisions that allow the holder to retain some value of the option contract even if the barrier price is not reached. It might be a percentage of the premium paid from the execution of the trade.
This might be seen as a less risky version of barrier options as it is not an all-or-nothing approach.
Turbo Warrant Barrier Options
Turbo warrant barrier options are traded more actively in overseas markets. They are a category of down-and-out options and feature high leverage.
While they can be risky, turbo warranty barrier options are also less volatile than other types.
Parisian Option
Both time and price are key variables with Parisian barrier options. They work similarly to Asian options. They are different in that the underlying security’s price must not only cross the barrier but stay above that price for a predetermined time period before the contract is in effect.
The Takeaway
Barrier options offer traders another means to hedge a portfolio or speculate on an underlying asset. This type of option is exotic, meaning it is more complex than plain vanilla puts and calls.
With barrier “in” options, the call or put does not go into effect until a barrier price level is hit while “out” options are active until the barrier price is touched.
Barrier options give investors more flexibility and customization at a cheaper price, but they can be more restrictive and less liquid than other options.
Qualified investors who are ready to try their hand at options trading, despite the risks involved, might consider checking out SoFi’s options trading platform. The platform’s user-friendly design allows investors to trade through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.
Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors.
FAQ
Are barrier options American or European?
Barrier options are complex exotic options different from the two common styles of options: American and European. While American-style options can be exercised at any time, before and at expiration, and while European-style options can be exercised only at expiration, barrier options are exercisable only after the barrier price is reached.
How are barrier options valued?
Barrier options have a path-dependent value since their worth is based on the underlying asset’s price movements. It is only when the underlying price crosses the barrier price that the option has value and can be exercised. If that predetermined barrier option price is never reached, then the option is worthless with a typical knock-out option. Knock-in options are non-exercisable until they reach the barrier price.
Can you replicate barrier options?
Some strategies can replicate the structure and payoff profile of barrier options. Many of these analyses were performed by academics over recent decades. The goal is often to produce sound portfolio hedging techniques.
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