Barrier Options

A barrier option is a path dependent option that has one of two features:

1.      A knockin feature causes the option to become effective only if the underlier first reaches a specified barrier level.

2.      A knockout feature causes the option to immediately terminate if the underlier reaches a specified barrier level, or

Premiums are paid in advance. Due to the contingent nature of the option, they tend to be lower than for a corresponding vanilla option.

As an example lets consider an "up-and-in" option. The underlying must first go "up" to the barrier before the option knocks "in."

In all, there are eight flavors of barrier options comprising European puts or calls having barriers that are:

up-and-in,

down-and-in,

up-and-out, or

down-and-out.

Of the eight, four either knock-in or knockout when they are in-the-money. These are called reverse barrier options. They can pose significant hedging challenges for the issuer.

Alternative structures include multiple barriers or barriers incorporated into other types of derivatives. For example, binary options can be structured with barriers.

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