SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

Some options produce a payoff if the underlying reaches a preset price. This is a great advantage of the barrier option because traders can expect profits (or worthless expiration) depending on the underlying behavior. The barrier refers to methods by which the underlying expires, as well as whether the price moves in the desired direction.

A knock-out barrier option expires worthless when the underling exceeds a preset price, so profit potential is limited. It can also be a knock-in barrier option, meaning value is generated only if the underlying reaches the predetermined price.

Why would a trader want to open a barrier option, given its limitations? These are path-dependent contracts, and this means even a temporary move in the underlying could immediately render the barrier option worthless.

A knock-out option is either an up-and-out or a down-and-out barrier contract. An up-and-out expires worthless when the price of the underlying goes higher than the preset price, and a down-and-out expires worthless when the underlying moves lower than the barrier set in advance.

The knock-in operates in the opposite manner. Rights of a holder begin only when the underlying reaches the known barrier at some point in the option’s life. Once it begins, it remains in effect until expiration date. It can be described as in-and-in or down-and-in. The up-and-in begins if the underlying price rises higher than the barrier, which will always be higher than the price of the underlying when the contract begins. A down-and-in begins and takes effect only when the underlying moves below a predetermined barrier, which is always lower than the underlying price at the time the contract is entered.

These contingent valuations make the barrier option interesting, and the ultimate value relies on direction of underlying movement. For the trader, selection of a barrier call or put determines whether it ultimately becomes profitable or just expires worthless.

Four other classification of barrier options are also worth consideration. The rebate barrier option provides that if the barrier is not reached and the option becomes worthless, a rebate will be paid. This is always lower than the premium paid to open the option, set as a percentage of the original cost.

The Parisian barrier option is one where the contract is not directly generated by the underlying reaching the barrier. Rather, the underlying must remain above or below the barrier price for a predetermined amount of time. This prevents undesirable outcomes due to spikes in price, which do not hold.

The turbo warrant barrier option is an unusual one, normally traded only in Hong Kong (and in some cases, in Germany). These are down-and-out options typically involving underlying securities with low volatility.

A discrete barrier option recognizes a move beyond the barrier only at specified times, versus the continuous barrier for most contracts.

Trading in barrier options is motivated in several ways. First, premium is typically lower than for better-known calls and puts, due to the restrictions built into the contracts. If a trader speculates that the barrier is not likely to be exceeded, the lower premium is desirable, and the barrier rule will not affect profitability. Of course, this is a risk. Some traders use barrier options to hedge equity positions, notably the knock-in variety. This provides a form of insurance to offset losses that otherwise would be suffered.

Figure 1

Some examples of barrier options:

  1. Knock-in: A trader buys an up-and-in call with a 30 strike and a barrier of 32.50. The underlying is trading at $27.50 per share. In this scenario, the barrier call option becomes live if the underlying price moves above $32.50 per share. If the underlying never exceeds this barrier, the option will expire worthless.
  2. Knock-out: A trader buys an up-and-out put with a barrier of 50 and strike of 40. The underlying traded at the time it was opened at $36 per share. If, during the lifespan of the put, the underlying moves above $50 per share, the option immediately expires worthless. This applies even if the barrier is passed only for one moment.

Parity can be achieved by combining an ‘in’ contract and an ‘out’ contract with identical prices and expirations. This sets up a situation in which one or the other will pay off the same amount as a standard option, and the other will expire worthless. This applies for all barrier options except those offering a rebate. A trader using this form of hedging would need to manage the insurance aspects of the parity strategy and be able to ensure overall profitability or reduced and limited loss.

When the underlying price crosses the barrier, it is termed a “barrier event.”  The mechanics of the event itself can be more complex than the general rules for the barrier. For example, does the event take place on an exchange or between private parties? Does the specific contract specify the number of trades required to define an event? Or does the event kick in with only a single trade beyond the barrier? The two sides need clear and precise definitions of what constitutes a barrier event, to avoid potential disagreements.

The method for valuation of barrier options is not as clear as it is for better-known calls and puts. This becomes complicated because, unlike vanilla options, the Black-Scholes method cannot be applied to set value. The most basic form of valuation is to apply a replicating portfolio of vanilla contracts, so that the barrier’s value can be set to mirror value at expiration or at discrete moments during the option’s life. The complication here is that it is based on Black-Scholes and assumes that model accurately identifies value. This is not universally agreed upon by traders.

Several more esoteric modeling methods can be used, including application of a binomial tree pricing system. However, the key takeaway here is that barrier options are complex, not only in the rules governing whether they exist, but also what their value will be at the point of payout.

Most traders may find barrier options appealing at first glance but finding an exchange that allows trading in them could be elusive. Even beyond that, the method of valuation should be thoroughly agreed by both sides, to avoid misunderstandings and disagreements later.

Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Publishing as well as on Seeking Alpha, LinkedIn, Twitter and Facebook. 

Related articles:



What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles


  • Tips to Improve Your Trading in 2021

    Making investments can be an effective way to increase your capital and even generate an income, but it can take time to develop trading skills. Whether you’re new to trading or you’ve been playing the markets for some time, there’s always more to learn. If you want to improve your returns, take a look at these top tips to enhance your trading in 2021:

    By Kim,

  • Binary Options: Proceed with Caution

    The binary option involves two possible outcomes, which are determined by whether the contract expires in the money. To profit from a binary option, a trader needs to be on the desired side. Exercise is automatic for these products, so that a profit or loss is added to or taken from the trading account immediately upon expiration.

    By Michael C. Thomsett,

  • Enhancing 60/40 With a Short Strangle Overlay

    The classic 60/40 stock/bond portfolio has stood the test of time in both hypothetical and live fund results from multiple fund sponsors such as Vanguard, Fidelity, and American Funds. 60/40 balances enough in equities (60%) to generate long-term growth with enough in high quality bonds (40%) to manage downside risk.

    By Jesse,

  • Getting Into Stocks and Shares Through the Pandemic Screen

    2020 and 2021 so far have been extremely difficult for many of us. Coronavirus and Covid-19 have spread across the world leaving havoc and chaos in their wake. We had to worry about the physical health of ourselves and our loved ones throughout this pandemic.

    By Kim,

  • Selling LEAPS - Not as Attractive as Short-term Options

    The LEAPS (long-term equity appreciation securities) is an option that does not expire for as long away as 30 months or so, but is it a better alternative than shorter-expiring contracts? Traders selling covered calls may be attracted to the premium of 11 on an ATM strike, versus the less appealing 1.5 on a 2-week contract.

    By Michael C. Thomsett,

  • Double Barrier Options

    The typical barrier option yields a payoff when the underlying reaches a predetermined price. Expanding on this idea is the double barrier option. This expansion of the barrier option is most applied to currency trading, indices, commodities, or OTC options, but not exchange-based trading.

    By Michael C. Thomsett,

  • Barrier Options

    Some options produce a payoff if the underlying reaches a preset price. This is a great advantage of the barrier option because traders can expect profits (or worthless expiration) depending on the underlying behavior. The barrier refers to methods by which the underlying expires, as well as whether the price moves in the desired direction.

    By Michael C. Thomsett,

  • First Time Trader? Here Are 3 Tax Tips You Should Know

    If you’re a first-time trader or this is your first year in the market, it’s important to know what to expect when it comes to your taxes. Now is the time of year to start thinking about your tax returns and what you’ll need to file. If just thinking about it gives you a headache, you’re not alone.

    By Kim,

  • Solicitors (Or How do I make money on this?)

    My firm is frequently asked if it can pay people for referrals, and the short answer is “probably.”  The SEC calls third parties who send investment clients to investment advisors “solicitors,” and there is a specific rule governing solicitors and solicitor arrangements – SEC Rule 206(4)-3.


    By cwelsh,

  • Lookback Options

    Most traders would agree that it would be a great advantage to decide whether to exercise an option with knowledge about past performance. Being aware of the odds an option will expire worthless gives the trader a significant advantage.

    By Michael C. Thomsett,


  Report Article

We want to hear from you!

There are no comments to display.

Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!

Register a new account

Sign in

Already have an account? Sign in here.

Sign In Now

Options Trading Blogs Expertido