Barrier Option

A vanilla that switches on or off at a level

A barrier option is a vanilla call or put with a trigger attached: it either comes to life when the underlying reaches a level (knock-in) or dies when it does (knock-out). The trigger is what the buyer sells to cheapen the option — a knock-out call costs less than the vanilla because it pays nothing along the paths that go furthest in its favour. Barriers are the most heavily traded exotic in FX and sit inside most structured notes, where the knock-out is what funds the enhanced coupon.

Open in the app · Exotics · intermediate

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What the lesson covers

1. What it is
2. How it works
3. Why it’s used
4. Key terms
5. Risks to watch

Key terms

• Knock-out — A barrier option that ceases to exist if the underlying reaches the barrier level.
• Knock-in — A barrier option that only becomes a live option once the barrier is reached.
• In-out parity — The rule that a matching knock-in and knock-out together equal the plain vanilla option.
• Rebate — A fixed amount paid to the holder when a knock-out barrier triggers, softening the loss.
• Reverse knock-out — A barrier set in the money, so the option is extinguished exactly when it is most valuable.
• Barrier shift — A dealer’s practice of hedging to a level slightly beyond the contractual barrier to make the risk tradable.

In practice

Corporate treasurers buy knock-out forwards and calls to cut the cost of a hedge they only need within a band, and structured note desks embed knock-ins to manufacture the conditional downside that funds a coupon. On the dealer side, barrier books are where FX options desks concentrate their gamma risk, and where the trading day is organised around which levels are close.

Read next

• FX Option — The right to exchange currency at a strike
• Digital Option — All or nothing, decided at one level
• Autocallable Note — A coupon note that can retire itself early

In the app, Barrier Option carries a five-step lesson, a worked example and a bank of twelve questions drawn differently every sitting.

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Educational content only. Nothing here is financial advice, an offer to trade, or a recommendation to buy or sell any instrument.