Barrier options

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Knock-in Reverse knock-in Knock-out Reverse knock-out

Barrier options – knock in, knock out, reverse knock in, reverse knock out – belong to the category of exotic options (as opposed to vanilla options). They name comes from the fact that they only become valid (or they are invalidated) if a certain trigger level (the barrier) is reached.

Definition: The knock option becomes effective (it is “knocked in”) only if a pre-specified rate is reached. Once it becomes valid, the knock in option has all the characteristics of a regular put or call option. Like a standard option, if it is in-the-money at expiry, it will be exercised. If it is out-of-the-money, then it will expire worthless. If the knock-in level is never reached, it’s as though the option never existed. Knock-in options are often used in addition to standard options for cost-effective hedging strategies. Option price: The value of a knock in option is lower than that of a standard option since it may not come into effect at all. Usually, the further the knock-in level to the spot rate, the cheaper the option, since the chances of the option being exercised are smaller. Thus, the further the barrier from the market rate, the cheaper the option. Back to top

Reverse knock-in
With a reverse knock-in option, the barrier is triggered when the option is in the money (i.e. above spot for a call, or “up and in” and below spot for a put or “down and in.” Like the knock-in, the reverse knock-in is cheaper than standard put and call options (vanilla). a KI. Back to top

Definition: Knock-out options work the same way as knock-in options except for the fact that as their name suggests, they are knocked out when a pre-specified rate is reached. Until the spot level reaches the knock out, it runs like a regular vanilla option. However, if it does reach the barrier, the option is knocked out and expires, as though it never existed. The knock-out option is triggered when it is out-of-the-money. Option price: Knock-out options are significantly cheaper than their standard vanilla counterparts since it may very well be knocked out during the option’s life time. Back to top

Reverse knock-out
The difference between a reverse knock out option and a knock out option is that whereas the latter has a barrier which is triggered at a level when the option is out-of-the-money, the barrier of the former is triggered at a barrier which is in-the-money (above spot for a call and below spot for a put.) If the barrier is not reached the lifetime of the option, the payout is the same as for a standard put or call option. And since the payout is limited by the trigger, reverse knock out options are usually much cheaper than standard options (and cheaper than regular knock outs).