The barrier options are classified as exotic options. They are similar to normal option contracts, but have an important feature that is absent in other types of options: the barrier, which is at a fixed price and in which the contract is activated or terminated. Barrier options are particularly common in forex.
There are two types of barrier options: European-style and American-style, although the former is mainly used. Other basic types are call and put.
Knock-In and Knock-Out
Barrier options are classified as knock in and knock out. A knock-in price is initially inactive and becomes active when the underlying security reaches a predetermined price. This price is specified in the contract.
A knock out price immediately starts to be active and is automatically canceled when it reaches the pre-established one. If canceled, it becomes useless and cannot be reactivated even if the share price reverses.
There are two types of knock-in contracts and knock-out contracts. Knock-ins are classified as up-and-in or down-and-in, while knock-outs are classified as up-and-out or down-and-out.
The knock-in price in the up-and-in contract is higher than the current price of the underlying security. Become active if the share price exceeds the knock-in price. If the share price was unable to reach the knock-in price before the expiration, the contract expires without any value.
A down-and-in option also starts in sleep mode. The knock-in price is set below the current market price of the underlying security. The contract is activated when security falls below the knock-in price. Again, if the security does not reach the knock-in price on maturity, the contract expires worthless.
These contracts are generally settled in cash. This means that there is no need to physically buy the underlying shares and then sell them to make a profit.
An up-and-out option contract is a type of knock-out contract. Start being active. At any time prior to expiration, if the security moves above the specified knock-out price, the contract expires automatically. Once the knock out is reached, the contract is definitively terminated. It is mandatory to go out.
Down-and-out is another type of knock-out option. This option also begins to be active. In a down-and-out option contract, the knock-out price is lower than the current market price of the security. If the security falls below the knock-out price at any time before expiration, the contract automatically expires again.
Double barrier options
Double barrier options are another type of knock-out contract. They are also known as double knock-outs. They are a combination of an “up-and-out” contract and a “down and out” contract and have two “knock out” prices. The first is the price is above the price of the underlying security, while the second is the price below the share price.
Therefore, a double barrier contract can be exercised if the security moves significantly in both directions. This increases the risk for the buyer as the chances of a contract expiring worthless are high.