BAJAJ BROKING
September 30, 2024
4 mins read
Barrier options are extremely unique options whose value is defined through the underlying asset’s potential to reach a specific barrier limit. Barrier options are also known as knock-in or knock-out options. Barrier options have carved a special niche for themselves in the options market because their price and payoff are dependent on the underlying asset breaching or not breaching the predetermined barrier limit.
Here is everything you need to know to understand what barrier options are:
A barrier option is where the potential payoff depends on whether or not the underlying asset’s value will reach a predetermined level, known as the barrier.
This needs to be achieved during the option’s lifespan.
A barrier option’s value is dependent on the asset’s ability or inability to breach the barrier.
Barrier options can be divided into two main categories: knock-in and knock-out options.
Knock-in options:
Take place or “knocked-in” when the underlying asset’s price reaches the barrier level.
The value of the option increases when the barrier is breached and from here it behaves like any other option
Knock-out options:
They are active by default from the issuance of the option
They become deactivated or “knocked out” when the underlying asset’s price reaches the barrier level.
The option ceases to exist after this and holders cannot exercise it anymore.
Here is everything you need to know about the working of barrier options:
Knock-in options become valid and also gain value when the underlying asset’s price meets or breaches the barrier level.
When the option gets ‘knocked in’ in this manner, they start behaving like every other option
Holders can now exercise the option.
Knock-out options, on the other hand, are active, by default, from the get-go
They become ‘knocked out’ and lose their value if and when the underlying asset’s price meets or breaches the barrier level.
The option then ceases to exist and the holder can no longer exercise it.
With all this in mind, investors and traders need to mould their strategy accordingly.
As an example, if a trader expects the price of an underlying asset to reach the barrier level, choosing a knock-in option would be ideal for them.
Alternatively, if they think that the asset’s price is likely to touch the barrier and reverse, a knock-out option would better suit them.
Various types of barrier options come with their own features and activation/deactivation rules. The different types of barrier options are listed below:
Up-and-In Barrier Option
The up-and-in option stays inactive till the underlying asset’s price reaches the barrier level.
Once the option crosses the barrier level, it becomes active, behaves like a standard option and can be exercised by the holder.
Up-and-Out Barrier Option
Active by default from the get-go becomes invalid and loses all value when the underlying asset’s price touches the barrier level.
The option ceases to exist once the barrier is breached, resulting in a complete loss for the holder.
Down-and-In Barrier Options
These options remain inactive till the underlying asset’s price falls below the barrier level.
Once it breaches the barrier it becomes active and holders can exercise it.
Down-and-Out Barrier Options
These options are active from the get-go but lose their value when the underlying asset’s price touches or falls below the barrier level.
The option ceases to exist when this happens and the holder cannot exercise it.
Some of the main advantages of barrier options are listed below:
Barrier options are more cost-effective than standard options as they have lower premiums which works great for traders with limited capital.
When it comes to structured trades, barrier options provide more flexibility as investors can set their barrier levels.
The barrier levels in barrier options can also be customised to meet an investor’s risk appetite providing greater control over potential losses and gains.
Since barrier options are also conditional in nature, the potential to generate higher returns also exists for traders.
Below are two examples of barrier options:
Aspect | Example |
Knock-In Barrier Option | Suppose an investor purchases an up-and-in call option having a strike price of ₹600. The barrier level is set at ₹650 when the underlying stock is at ₹550. In such a case, the up-and-in option would not become active till the underlying stock’s price goes beyond ₹650. Though investors pay for the option keeping in mind its potential to become valuable, it becomes applicable only according to the condition mentioned above. In case it doesn’t reach the barrier, the option is never triggered and the buyer loses the price they paid for it. |
Knock-Out Barrier Option | Suppose an investor purchases an up-and-out put option having a strike price of ₹200. The barrier level is set at ₹250 when the underlying stock is at ₹180. If in this case, the value of the underlying asset’s value goes above ₹250 in the option’s lifetime, it will cease to exist. The option now becomes worthless, even if it briefly touches the ₹250 barrier drops back below |
Here’s a look at how barrier options help in managing risks.
Barrier options play a crucial role in protecting a portfolio against adverse price movements.
Despite the protection offered, barrier options allow traders to participate in favourable price movements.
By setting predetermined barriers in barrier options, traders can limit potential losses or gains.
When investors use barrier options in their hedging strategies, their risk exposure and impact of market volatility can decrease to a great extent.
Take for instance a bullish market outlook. Here an investor can use an up-and-in option to decrease any potential downside risk while benefiting from potential gains.
In a bearish market outlook, on the other hand, a down-and-out barrier option can help utilize short-term price fluctuations while staying protected from them.
While there are many benefits of using barrier options, there are certain challenges that accompany them as well. The main drawback or challenge that exists here is the difficulties that come with trying to predict how the underlying asset’s price might move. With the barrier level comes more challenges as it is another factor that needs to be taken into account when making such predictions. These complications can add to an investor’s stress making it difficult for them to make well-researched and informed investment decisions.
To add to this, barrier options are found to be more susceptible to sudden price spike risks. In case an underlying asset’s value is subjected to a sharp and unexpected increase or decrease, the barrier option can also suddenly get activated and deactivated. This sudden and unexpected movement can cause unexpected outcomes and potential losses for the investor.
A barrier option, like other options, offers the buyer the right, but not the obligation, to buy or sell an underlying asset. This is done at a predetermined price if and when the underlying asset’s price reaches a certain barrier level. Barrier options provide more flexibility to investors and hold more potential for higher returns. However, they too come with higher risks.
Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing. This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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Barrier options are extremely unique options whose value is defined through the underlying asset’s potential to reach a specific barrier limit. Barrier options are also known as knock-in or knock-out options. Barrier options have carved a special niche for themselves in the options market because their price and payoff are dependent on the underlying asset breaching or not breaching the predetermined barrier limit.
Knock-in options become valid and also gain value when the underlying asset’s price meets or breaches the barrier level. When the option gets ‘knocked in’ in this manner, they start behaving like every other option
Knock-out options, on the other hand, are active, by default, from the get-go. They become ‘knocked out’ and lose their value if and when the underlying asset’s price meets or breaches the barrier level and ceases to exist
Barrier options are more cost-effective as they have lower premiums, provide more flexibility as investors can set their barrier levels which can be customised to meet an investor’s risk appetite and as they are conditional in nature, the potential to generate higher
There are four types of barrier options available; Up-and-In, Up-and-Out, Down-and-In and Down-and-Out barrier options
Barrier options play a crucial role in protecting a portfolio against adverse price movements. Despite the protection offered, barrier options allow traders to participate in favourable price movements. By setting predetermined barriers in barrier options, traders can limit potential losses or gains.
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