Barrier option is a type of financial option where the option to exercise depends on the underlying crossing or reaching a given barrier price. Barrier options exist in many forms. They are similar in some ways to ordinary options. There are put and call, as well as European and American varieties. Depending on the type of barrier option used, when the spot price of underlying asset hits the barrier (trigger) price, the option will either appear (be ”knocked in”) or disappear (be “knocked out”). The premium charged for the barrier option is usually lower than the premium charged for plain vanilla options. The existing barrier gives writer some kind of insurance that the final payoff won’t deviate too much. The closer is the barrier to the strike price, the greater are the cost savings from premium, but also less likely that instrument will survive daily fluctuations.
“In” options start their lives worthless and only become active in the event a predetermined knock-in barrier price is breached. “Out” options start their lives active and disappear in the event a certain knock-out barrier price is breached.
Knock-out options are the most common type of barrier options. If the barrier (trigger) price is above the strike price, it is an “up-and-out” option and if the barrier (trigger) is bellow the strike price; it is a “down-and-out” option. The payoff of the knock out is the same as a standard option unless the underlying price touches the trigger price. In this case the option disappears. Up-and-out calls and down-and-out puts are automatically exercised when the underlying financial price reaches the trigger price; this serves to cap the gain on the option at the predetermined level.
Knock in options are the form of barrier options are the form of the barrier option in which the option appears only when the barrier (trigger) price is reached. Up-and-in calls and down-and-in puts are activated when the trigger price is reached, producing a standard contract.
Sources:
[1] Smith, Clifford W.; Managing financial risk, Harper & Row, Ballinger Division, New York, 1989
[2] wikipedia.com
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