Now, in a barrier option, an additional level is placed. Say this level (H) is at $4.30. If the underlyingstock of $4.00 reaches level H of $4.30 within the stipulated tenor, two things may occur:I.
The option will cease immediately, or is knocked out, or called. The payoff to the investorwhen this happens is simply the barrier level minus the strike price (H-X or $4.30 - $3.50).Note that in a standard option, the payoff to the investor would be S
– X; S
being thefuture price of the underlying stock which could be above or below its current price, $4.00. Itis obvious here that with a barrier in place, the investor is limiting his upside as he seemssatisfied when S
reaches a particular level (in this case when S
reaches H of $4.30).Intuitively we would expect the premium of the barrier then to be cheaper than a standardoption. This is one of the key motivations for the investor to trade barrier options.II.
The option will start its life- or the option “knocks in”. Here the option only starts when thestock price reaches $4.30. When this happens, S
will now be $4.30 and X is still $3.50. It willthen behave like a standard option.The barrier, H can be set above the stock price as in the above example or below the stock price.When the barrier is set above S
, the investor is bullish about the stock. We then have either an “Up& Out” or an “Up & In” option. When the barrier is set below S
, the investor is bearish about thestock and we have a “Down & Out” or a “Down & In” option. These properties are illustrated in
Chart 1 – The Standard Option vs. Barrier Options
The main motivation for using barrier options is that it involves less upfront cost (premium) and itdoes not require vigilant monitoring by the investor to match his personal stop loss criteria. This of course comes at a price -the payoff the investor gets with a barrier is limited (to H) compared to thestandard option where his upside is unlimited. Note that in both barriers and standard options, thedownside is limited to the premium paid upfront.
CBBCs – a case of a Knock Out Barrier Options
CBBCs are actually specific knock out barrier options, designed for the retail investors. In manymarkets, only in-the-money types of CBBC options are traded. A standard knock out call option forexample, when purchased, may be in any of the following three states: