A barrier option is an option whose existence depends upon the underlying asset's price reaching a preset barrier level.
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:
- Up-and-out: spot price starts below the barrier level and has to move up for the option to be knocked out.
- Down-and-out: spot price starts above the barrier level and has to move down for the option to become null and void.
- Up-and-in: spot price starts below the barrier level and has to move up for the option to become activated.
- Down-and-in: spot price starts above the barrier level and has to move down for the option to become activated.
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.
In-out parity is the barrier option's answer to put-call parity. If we combine one "in" option and one "out" barrier option with the same strikes and expirations, we get the price of a vanilla option: . A simple arbitrage argument—simultaneously holding the "in" and the "out" option guarantees that exactly one of the two will pay off identically to a standard European option while the other will be worthless. The argument only works for European options without rebate.
A barrier event occurs when the underlying crosses the barrier level. While it seems straightforward to define a barrier event as "underlying trades at or above a given level," in reality it's not so simple. What if the underlying only trades at the level for a single trade? How big would that trade have to be? Would it have to be on an exchange or could it be between private parties? When barrier options were first introduced to options markets, many banks had legal trouble resulting from a mismatched understanding with their counterparties regarding exactly what constituted a barrier event.
Barrier options are sometimes accompanied by a rebate, which is a payoff to the option holder in case of a barrier event. Rebates can either be paid at the time of the event or at expiration.
- A discrete barrier is one for which the barrier event is considered at discrete times, rather than the normal continuous barrier case.
- A Parisian option is a barrier option where the barrier condition applies only once the price of the underlying instrument has spent at least a given period of time on the wrong side of the barrier.
- A turbo warrant is a barrier option namely a knock out call that is initially in the money and with the barrier at the same level as the strike.
The valuation of barrier options can be tricky, because unlike other simpler options they are path-dependent – that is, the value of the option at any time depends not just on the underlying at that point, but also on the path taken by the underlying (since, if it has crossed the barrier, a barrier event has occurred). Although the classical Black–Scholes approach does not directly apply, several more complex methods can be used:
- The simplest way to value barrier options is to use a static replicating portfolio of vanilla options (which can be valued with Black–Scholes), chosen so as to mimic the value of the barrier at expiry and at selected discrete points in time along the barrier. This approach was pioneered by Peter Carr and gives closed form prices and replication strategies for all types of barrier options, but usually only by assuming that the Black-Scholes model is correct. This method is therefore inappropriate when there is a volatility smile. For a more general but similar approach that uses numerical methods, see Derman's "Static Options Replication."
- Another approach is to study the law of the maximum (or minimum) of the underlying. This approach gives explicit (closed form) prices to barrier options.
- Yet another method is the partial differential equation (PDE) approach. The PDE satisfied by an out barrier options is the same one satisfied by a vanilla option under Black and Scholes assumptions, with extra boundary conditions demanding that the option become worthless when the underlying touches the barrier.
- When an exact formula is difficult to obtain, barrier options can be priced with the Monte Carlo option model. However, computing the Greeks (sensitivities) using this approach is numerically unstable.
- A faster approach is to use Finite difference methods for option pricing to diffuse the PDE backwards from the boundary condition (which is the terminal payoff at expiry, plus the condition that the value along the barrier is always 0 at any time). Both explicit finite-differencing methods and the Crank–Nicolson scheme have their advantages.
- A simple approach of binomial tree option pricing also applies.