Barrier Options Explained

Knock In and Knock Out

In the first instance, barrier options contracts can be either knock in or knock out. The fundamental difference between these two is that knock ins require the underlying security to reach a certain price for the option to be activated while knock outs are terminated if the underlying security reaches a specified price.

A knock in contract starts out inactive and only becomes active when the underlying security reaches a predetermined price that is specified in the contract. This price is known as the knock in price. A knock out contract starts out active, but is automatically cancelled if the underlying security reaches a predetermined price known as the knock out price. Once a knock out contract is cancelled, it's worthless cannot be reactivated even if the underlying security reverts in price.

There are two main types of knock in contracts and two main types of knock out contracts. Knock ins can be either up-and-in or down-and-in, and knock outs can be either up-and-out or down-and-out. Further details on each these, with examples, can be found below.

Up and In

An up and in barrier options contract starts out dormant, and contains a knock in price that is above the current price of the underlying security. It only becomes active if the underlying security moves above the knock in price. If the expiration date is reached without the underlying security reaching the knock in price then the contract expires without any value. Although some contracts pay the holder a rebate it is usually only a small percentage of the original price.

Example of an up and in

• Call Option
• European Style
• Based on stock in Company X
• Company X stock currently trading at $50
• Strike Price of $55
• Knock In Price of $60
• No rebate

If you bought the above contracts and the price of Company X stock never reached the knock in price of $60 before the expiration date then your contracts would expire without value, even if the stock was trading above the strike price of $55. If the stock price was $60, or higher, at the expiration date then your options would become active. You could then exercise and buy the stock at $55 and make a profit. Alternatively you could sell the contracts at some point prior to the expiration date if you were able to make a profit in that way.

Down and In

A down and in barrier options contract also starts out dormant. The knock in price is set at a price that is below the current trading pricing of the underlying security, and the contract is activated only if the security falls below that knock in price. As with an up and in, if the security does not reach the knock in price by the expiration date then the contract expires worthless.

Example of a down and in

• Put Option
• European Style
• Based on stock in Company X
• Company X stock currently trading at $50
• Strike Price of $45
• Knock In Price of $40
• No rebate

If you owned the above contracts and the price of Company X stock either went up, stayed static, or didn’t fall as low as the knock in price by the date of expiration, then those contracts would expire. If the stock fell to $40, or lower, then on the expiration date you would be able to exercise to realize a profit.

Such contracts are often based on cash settlement, which means you wouldn’t actually have to buy the underlying security and then sell it for a profit. However you would only receive your profits in cash. You may also be able to sell your contracts for profit at some point before the expiration date if their value had increased.

Up and Out

An up and out barrier option is a type of knock out contract, which means it starts out active. The contract automatically expires, though, if the price of the underlying asset moves above the specified knock out price before the expiration date. If the knock out price is reached then the contract is terminated permanently and basically ceases to exist.

Example of an up and out

• Call Option
• European Style
• Based on stock in Company X
• Company X stock currently trading at $50
• Strike Price of $55
• Knock Out Price of $60
• No rebate

If you owned contracts with the above characteristics, then you would be hoping for the underlying stock to move above the strike price, but stay below the knock out price. If the price of the stock was at $59 on the expiration date then you would be able to exercise and make a profit. However, if the stock went above $60 at any time, then the contract would automatically expire with a value of zero.

Down and Out

A down and out barrier options contract is also a type of knock out, meaning that the contract starts out active. With a down and out, the knock out price is set at a price below the current price of the underlying security. Should the price of the security falls below the knock out price at any time during the term of the contract, then the contract would also expire.

Example of a down and out

• Put Option
• European Style
• Based on stock in Company X
• Company X stock currently trading at $50
• Strike Price of $45
• Knock Out Price of $40
• No rebate

If you bought contracts with the above terms, then you would be anticipating the underlying stock to fall in value, but only by a moderate amount. If the stock price was lower than the strike price of $45 but higher than the knock out price of $40, at the time of expiration then you would be able to exercise to make a profit. If they were cash settled options, then you would receive a pay-out under those circumstances. However, if the price of the stock fell below the knock out price of $40 at any time, then the contracts would cease to exist.

Double Barrier Options

Double barrier options are another form of knock out contract, also known as double knock-outs. These are effectively a combination of the up and out contract and the down and out contract. They have two knock out prices: one that is above the price of the underlying security at the time of the contract being written and one that is below that price. Therefore, a double barrier can be knocked out if the price of the security moves significantly in either direction. This increases the risk of the holder of the contract seeing their investment expire worthless.

Advantages of Barrier Options

Barrier options carry a higher risk to the holder than the more standard types of contracts. With a knock in contract, the holder needs the price of the underlying security to move a certain amount if they are to exercise for a profit. This means that if the underlying security only moves a little in price there may be no profits to be taken.

With a knock out contract, the holder carries the risk of their investment basically ceasing to exist if the underlying security moves significantly and reaches the knock out price. Double barrier options carry even more risk, as price movements in either direction can result in the contracts expiring.

There is, however, one fairly significant advantage that barrier options offer traders, regardless of what trading strategies they are using. Because of the increased risk that the holder has to take, barrier options are generally cheaper than contracts that do not include a barrier price. This allows for greater profitability should you correctly predict price movements in the relevant underlying security.

As a basic rule, if you were expecting significant price movements in the underlying security then you would invest in knock in contracts. If you were expecting small price movements then you would invest in knock out contracts.

Buying & Selling Barrier Options

Barrier options contracts are traded only in the over the counter markets rather than the more accessible exchanges. The OTC markets are not as easy to access as not all brokers will allow you to buy and sell contracts that are not traded on the public exchanges. However, there are a number of brokers that do. Please see our recommendations for the Best Brokers for OTC Options.