Definition
Barrier options have a price trigger (barrier) that either activates (knock-in) or deactivates (knock-out) the option. Knock-in options come into existence when the barrier is hit; knock-out options cease to exist. Because the barrier condition reduces the probability of payout, barrier options are cheaper than equivalent vanilla options—useful for reducing hedging costs.
lightbulb Example
A down-and-out put on a stock at $100: strike $95, barrier $85. If the stock drops to $90, the put is in-the-money at $5. But if it drops to $84 first, the option is knocked out and becomes worthless regardless of subsequent price action.
verified_user Key Points
- Knock-in: activated when barrier hit
- Knock-out: deactivated when barrier hit
- Cheaper than vanilla options due to barrier condition
- Gap risk around the barrier level