What is a barrier option?

Definition and Example of Barrier Options

Investors use options to try to make profits based on expectations of whether the stock price will rise or fall. Options provide investors a means to profit and enhance their portfolios.

Investors can structure options contracts in several ways beyond standard put and call options. A unique type of option is the barrier option. Learn how barrier options work and why investors use this option structure.

How Do Barrier Options Work?

Barrier options are very similar to traditional put and call options. Two investors agree on the terms of the contract, including the contract price, strike price, barrier price, and expiration date. The option holder then has the option, but not the obligation, to exercise the contract if they choose to.

The main difference is that barrier options impose additional restrictions on the contract. With a traditional option, the option holder can exercise the option at any time before the expiration date. Barrier options add additional rules regarding when the contract can be exercised based on changes in the underlying stock price.

The advantage of barrier options is that they provide investors with more flexibility in defining the terms of their contracts. An investor may be willing to sell a call option but is concerned about losing a substantial amount of money, for example, if the stock price rises significantly. Barrier options that render the option ineffective at a certain price can help limit the seller’s losses in a scenario where their potential losses would otherwise be severe.

Note: Leveraged investment strategies, such as using options, aim to magnify returns. Leverage can also increase risks to the point where you can lose more than you invested.

Advantages and Disadvantages of Barrier Options

Advantages

Lower risk for option sellers: Option sellers can reduce their risk either by limiting their potential losses with an “ineffective” option or by reducing the likelihood of the option being exercised with an “effective” option.

Lower premiums for option buyers: Since barrier options have more restrictions than traditional options, they often carry lower premiums.

More freedom in customizing the contract: Barrier options allow investors to add additional terms to the contract, giving them greater freedom in creating the specific deal they want.

Disadvantages

More restrictions on the option holder: Barrier options make it harder for the option holder to exercise the contract. These restrictions may make it difficult to profit from the contract.

Barrier options are more complex: Barrier options can be more difficult to understand than traditional options, making them less appealing to average investors.

Less liquidity than traditional options: As an exotic option, barrier options are traded over the counter, meaning fewer people trade them and it may be difficult to find a buyer or seller if you wish to engage in barrier options.

What Does This Mean for Individual Investors?

Barrier options are considered exotic options. Exotic options are extremely complicated compared to simple put and call options and are usually not traded widely on exchanges. Instead, they are traded over the counter.

Between their complexity and low trading volume, regular individual investors may find it challenging to use barrier options in their investment plans. If you are interested in using derivatives, traditional put and call options are a simpler trading strategy to consider.

Key Takeaways

Barrier options work similarly to put and call options but have additional restrictions on when the option can be exercised.

A barrier option is dormant until the underlying security reaches a certain trigger point known as the barrier price.

No

“Internal” options can be exercised until the underlying stock reaches the barrier price.

“External” options can be exercised immediately, but they become unexercisable once the barrier price is reached.

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Source: https://www.thebalancemoney.com/what-is-a-barrier-option-5215539