A down-and-in barrier option is a barrier option which gives its holder the right to buy or sell an underlying asset if the price of the underlying asset falls below a predefined limit (the barrier level) over the option’s lifetime.
Down-and-in barrier options can be used by investors who expect the price of an asset to drop over a certain time frame. They can be used by asset owners who expect the value of their assets to increase over time to earn returns on their assets without selling them.
In the case of a call option, a strike price is agreed to by both parties to the down-and-in barrier option contract - the investor and the owner of the underlying assets. If the price of the underlying asset falls below the barrier level during the option term, then the investor who holds the option can exercise their right to purchase the underlying assets at the strike price. If the price of the underlying asset does not fall below the barrier level, the option becomes invalid.
The investor pays the asset owner a premium when the option is created. This premium belongs to the asset owner regardless of whether or not the option can be exercised.
In the case of a put option, the option grants the asset owner the right to sell their assets to an investor at the strike price if the price of the underlying asset falls to or below the barrier level. In this case, the asset holder pays the investor an option premium.
Down-and-in barrier option example 1:
An investor and an asset owner enter into a down-and-in barrier put option contract. The underlying assets – 300 ounces of gold bullion – trades at 1250 Swiss francs per ounce at the time the option is created.
Both parties agree to a barrier level of 1240 francs, a strike price of 1242 francs and an option term of 12 months.
In exchange for the rights granted them by the option, the asset owner pays the investor a premium of 2 francs to the gold fine ounce – or 600 francs total.
Within the 12-month term, the gold price falls to 1237.50 francs per ounce.
The owner of the gold exercises their right to sell the gold to the investor at the strike price of 1242 francs per ounce for a total of 372,600 francs. After accounting for the 600-franc option premium, the asset owner is still left with a 750-franc profit above the market price of 371,250 for their 300 ounces of gold.
Down-and-in barrier option example 2:
Using the down-and-in barrier option in the above example, if the price of the underlying gold had not fallen to or below 1240 francs, the option would have become invalid. The asset owner would lose the 600 francs paid to the investor for the rights granted by the option, which would result in a 600-franc profit for the investor.