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What Is a Double Barrier Option?

John Lister
By
Updated Feb 12, 2024
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A double barrier option is a type of financial derivative based on a normal options contract in which one party has the right to complete an agreed deal under agreed terms on an agreed future date. With a double barrier option, there are consequences if the price of the underlying asset reaches a set level before the option comes due. Usually the consequence is either that the deal is automatically and immediately completed, or that the entire agreement is canceled.

A simple option is a derivative, meaning it derives its value from an underlying asset such as stock in a particular company. The option involves party A paying party B a negotiated amount of cash now to agree the right but not the obligation to buy a set amount of the stock from party B at a fixed price on a future date. Whether A chooses to exercise the option will depend on the actual market price of the stock on this date and thus whether she can buy the stock and immediately sell at a profit.

With a double barrier option, there are two trigger prices. If the market price of the underlying asset reaches one of these trigger prices before the option comes due, a specific outcome is triggered. As an example, imagine the two parties have agreed upon an option involving a stock with the current market price of $1.50 US Dollars (USD), with the option being for A to buy the stock from B at $1.75 USD in three months' time.

The first trigger price is known as a knock-in price, meaning party A gains a new option if this price is reached. In the example, there could be a knock-in price of $2 USD triggering an immediate option of $1.85 USD. This means that if the stock price hits $2 USD before the three months is up, party A has the choice of immediately buying at $1.85 USD, or waiting until the three months is up to buy at $1.75 USD, thus hoping the market price remains high.

The second trigger price is known as a knock-out price, meaning the deal immediately ends. In the example, the knock-out price could be $1.25 USD, meaning that if the stock falls this low, the deal is canceled immediately. Depending on the terms of the agreement, party B may have to return the payment party A made to set up the deal.

Depending on the specific prices, it is possible for both the knock-out and knock-in prices in a double barrier option to favor one party over the other, for example by limiting risk. Alternatively the knock-out could favor one party and the knock-in could favor the other. This added complexity can alter both the price party A pays to party B to set up the deal, as well as the price party A will demand if she trades her position in the deal to a third party before the option comes due.

WiseGeek is dedicated to providing accurate and trustworthy information. We carefully select reputable sources and employ a rigorous fact-checking process to maintain the highest standards. To learn more about our commitment to accuracy, read our editorial process.
John Lister
By John Lister
John Lister, an experienced freelance writer, excels in crafting compelling copy, web content, articles, and more. With a relevant degree, John brings a keen eye for detail, a strong understanding of content strategy, and an ability to adapt to different writing styles and formats to ensure that his work meets the highest standards.
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John Lister
John Lister
John Lister, an experienced freelance writer, excels in crafting compelling copy, web content, articles, and more. With...
Learn more
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