What are Barrier Options?

Barrier options are a type of option. Options are contracts that give you the right to buy or sell something at a set price by a certain date. Barrier options are a special kind of option where that right to buy or sell only starts or stops if the price of the thing you’re trading hits a trigger price called the “barrier.”

The Four Main Types

There are four main types of barrier options:

1. Up and In: You only get the right to exercise the option if the price goes above the barrier price.
2. Up and Out: You have the right to exercise until the price goes above the barrier. Then you lose that right.
3. Down and In: You only get the option right if the price goes below the barrier.
4. Down and Out: You have the option right but lose it if the price drops below the barrier.

How Are Barrier Options Different?

Barrier options are different from regular options in a few key ways:

The Option Can Disappear

With normal options, you always have the right to exercise until expiration. But with barrier options, that right can appear or disappear based on price movements. This makes them riskier.

They Are Cheaper

Because there’s a chance you might never get to exercise, barrier options usually cost less than regular options. The further the barrier price is from the current market price, the cheaper the option.

They’re Based on European Options

The options that underlie barrier options are usually European style. That means you can only exercise them at expiration, not any time before that like with American options.

Why Use Barrier Options?

People and companies might use barrier options for a few reasons:

To Get Cheaper Protection

If you want to hedge against a possible price move, barrier options can do that for a lower cost than regular options. As long as you’re okay with the protection going away if prices hit the barrier.

To Speculate on Price Moves

Barrier options are a cheap way to bet on whether you think prices will pass a certain level or not. Sort of like an on/off switch for your market bet.

To Get Paid to Take Risk

Some investors will sell barrier options, pocketing the premium up front. They’re betting the barrier won’t get hit so the option will expire worthless. It’s riskier but can be profitable.

Real World Example

Let’s say GE stock is trading at $10. You think it might drop below $8 in the next month. You could buy a regular $8 put option but it’s expensive.

Instead you buy an $8 down and in put. It’s much cheaper since you don’t have the right to sell until GE drops below $8. If it does fall under $8, your put activates and you can exercise it for a profit. But if GE never drops below $8, your down and in put will expire worthless.

The Risky Nature of Barrier Options

Barrier options are risky for a few reasons:

The All or Nothing Barrier

The fate of your whole trade can rest on a single price point. If GE drops to $7.99 your put suddenly springs to life. But at $8.01 it stays inactive. This can make barrier options feel like gambling.

Pricing is Complex

Options pricing is based on complex math. Barrier options have the extra complexity of the barrier conditions. Mistakes in pricing them can be costly.

They Can Encourage Excessive Risk Taking

Because they’re cheap, barrier options may tempt people into risky bets they wouldn’t make with regular options. Overusing them can blow up your portfolio if too many barriers are breached.