Investors use options to try to earn profits based on predictions about whether a stock will rise or fall in value. Options give investors a way to earn profits and leverage their portfolios.
Investors can structure options contracts in several ways beyond the typical call and put options. One unique type of option is the barrier option. Learn how a barrier option works and why investors use this option structure.
Definition and Example of a Barrier Option
A barrier option is a type of exotic option, which means it is more complex than a simple call or put that has trigger points for activation.
Unlike other types of options, the call or put options of barrier options do not go into effect until a specific price, called the barrier price, is reached. In some cases, a barrier option may also become ineffective when a barrier price is reached.
With a normal call, Jane could exercise the option at any time and she would see a profit if she did so at any time XYZ was priced over $50. However, because there is a barrier of $55, Jane cannot exercise the option until XYZ rises above $55. This limits her flexibility and gives John a better chance of not losing money.
While “in” options are only exercisable once the barrier price is reached, there are also “out” options. These options start out active and become non-exercisable if the barrier price is reached.
How Does a Barrier Option Work?
Barrier options are very similar to traditional calls and puts. Two investors agree on the terms of the contract, including the price of the contract, the strike price, barrier price, and the expiration date. The option holder then has the option, but not the obligation, to exercise the contract if they want to.
The major difference is that barrier options place additional restrictions on the contract. With a traditional option, the option holder can exercise the option at any time up until the expiration date. Barrier options add additional rules as to when the contract can be exercised based on changes in the underlying stock’s price.
The advantage of barrier options is that they give investors more flexibility to set the terms of their contracts. An investor may be willing to sell a call option but worry about losing a large amount of money, for example, if a stock skyrockets in price. Barrier options that render the option ineffective at a certain price can help the seller limit their losses in a scenario where their potential losses would otherwise be significant.
Leverage investment strategies, such as using options, aim to magnify returns. Leverage can also increase your risk to the point where you could lose more than you invested.
Pros and Cons of Barrier Options
Less risk for the option seller
Lower premiums for the option buyer
More freedom to customize the contract
More restrictions placed on the option holder
Barrier options are more complex
Less liquidity than typical options
- Less risk for the option seller: Options sellers can reduce their risk by either limiting their potential losses with an “out” option or reducing the odds the option is exercised with an “in” option.
- Lower premiums for the option buyer: Because barrier options have more restrictions than traditional options, they often command lower premiums.
- More freedom to customize the contract: Barrier options let investors add additional terms to the contract, giving them more freedom to create the precise transaction they want.
- More restrictions placed on the option holder: Barrier options make it harder for the option holder to exercise the contract. These restrictions may make it harder 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 everyday investors.
- Less liquidity than typical options: As an exotic option, barrier options are traded over-the-counter (OTC), meaning that fewer people trade them and it may be harder to find a buyer or sell if you want to get involved with barrier options.
What It Means for Individual Investors
Barrier options are considered an exotic option. Exotic options are highly complex when compared to simple calls and puts and they generally aren’t widely traded on exchanges. Instead, they’re traded over-the-counter (OTC).
Between their complexity and low trade volume, average individual investors may have difficulty using barrier options in their investment plan. If you’re interested in using derivatives, traditional call and put options are a simpler alternative trading strategy to consider.
- Barrier options function similarly to call and put options, but they have additional restrictions on when the option can be exercised.
- A barrier option is dormant until the underlying security reaches a trigger point, called a barrier price.
- “In” options cannot be exercised until the underlying stock reaches the barrier price.
- “Out” options are active and can be exercised immediately, but they become inactive once the barrier price is reached.