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Definition: Barrier Option
A barrier option is a kind of exotic option whose payoff depends on whether the price of the asset has reached a predetermined price level. This fixed price level is known as Barrier. At this price the contract is either activated or terminated according to the type of the option.
Barrier option can be of European or American style, can be call or put, can be based on the number of underling securities. This is mainly used for foreign exchange market.
Basically barrier option can be in two ways:
• Knock in
• Knock out
A knock in option requires the underlying security to reach a certain limit to be activated. This price is known as knock in price. Below this price the option is worthless. It can be up and in or down and in.
An up and in option is when the knock in price is higher than current price. For example, if there is an asset of current price $10, strike price $15 and knock in price $20, then it becomes activated till it reaches $20.
On the other hand a down and in option is when the knock in price is less than the current price. For example, current price is $10, strike price is $8 and knock in price is $5, then it becomes activated till it reaches $5.
In this kind of option, the contract expires after the knock out price is reached. It can also two types- up and out, down and out.
In the above examples, it will be an up and out if the price goes above $20 and the contract expires. Similarly for down and out if the price falls below $5, then the contract expires.
These are effectively combination of two knock out option, they have two knock out price simultaneously. So it carries double risk. One price is above and one is below.
As the barrier option is riskier than other options it is cheaper than other options. If there is bigger price movement is expected, then knock in options are better otherwise knock out options are better for smaller variation.