In investing, an option is a contract that grants a buyer the right to choose to buy or sell an asset, a share for example, at an agreed price at some time in the future. A barrier option is a special kind of option where the right to buy or sell is dependent on a specified change happening to the price of the share on which the option is based. A simple example might be a situation where an investor wishes to purchase an option to buy shares in a certain company at a specified price, but only if the actual price of the shares rises above a certain level. Because barrier options bestow fewer rights on the investor than ordinary options, barrier option pricing is always lower than the equivalent option on the same shares, without the barrier.
There are two main variations of barrier options, ‘in’ and ‘out’ options. ‘In’ options are initially inactive, that is to say that the investor initially has no rights on the underlying share, so the option is, in effect, worthless. When the underlying share reaches the price specified in the barrier option formula, then the option activates. If the underlying share never reaches the specified price during the life of the option, then it expires with no value.
An ‘out’ option behaves in the reverse way. Such an option commences life as an active option that may be exercised. Then, if the underlying share crosses the specified barrier, either upwards or downwards, depending on the exact barrier that has been set up, the option expires and becomes null.
A barrier option rebate is a variation on this type of contract. In this type of option, the contract includes a clause stating that a pay out will be made to the investor under certain conditions. This would occur if the underlying share on which the option is based experiences a barrier event, that is to say crosses a predefined price level.
A double barrier option is another variation. In this contract, two separate barrier events are specified rather than just a single event. With an ‘in’ double barrier option, the investor is betting that the price of the underlying share will reach either one of the specified barrier prices. With an ‘out’ double barrier option, the reverse is the case. The investor is betting that the share price will stay between the two prices and not reach either one of them.