Barrier option

In investment, a barrier option is an exotic option on an underlying asset whose existence depends upon the underlying asset's price reaching pre-set barrier level: the derivative either springs into existence or, if the option already exists, it is extinguished.

A barrier option has a lower premium than a similar option without a barrier. Barrier options were created to provide the hedge of an option at a lower premium than a conventional option. For example, if an investor believes that the price of a particular , now trading at $100 per share, will increase within the next 6 months, but will not reach $150 per share, you could buy the option with a barrier level of $150 at a lower premium than a conventional option on the same common stock.

There are disputes over the tax treatment of these options in the United States.

Barrier options are path-dependent exotics that are similar in some ways to ordinary options. You can call or put in American, Bermudan, or European exercise style. But they become activated (or extinguished) only if the underlying reaches a predetermined level (the barrier).

"In" options start their lives worthless and only become active in the event that a predetermined knock-in barrier price is breached. "Out" options start their lives active and become null and void in the event that a certain knock-out barrier price is breached.

If the option expires inactive, then it may be worthless, or there may be a cash rebate paid out as a fraction of the premium.

The four main types of barrier options are:

For example, a European call option may be written on an underlying with spot price of $100 and a knockout barrier of $120. This option behaves in every way like a vanilla European call, except if the spot price ever moves above $120, the option "knocks out" and the contract is null and void. Note that the option does not reactivate if the spot price falls below $120 again. Once it is out, it's out for good. Also note that once it's in, it's in for good.

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