An up-and-out barrier option is a type of option which gives its holder the right to buy (call) or sell (put) an underlying asset if the price of the underlying asset does not match or exceed a predefined barrier level (the knock-out price, in this case) over the option’s lifetime.
This type of option is used by investors who believe that a specific asset’s value will either remain stable or decrease over a certain period of time.
When an up-and-out barrier option contract is created, both parties agree to a strike price – the price at which the underlying asset can be bought or sold if its price remains below the barrier level allowing the option to be exercised. As with other options, investors must buy up-and-out barrier options by paying a premium when the contract is created.
More complex up-and-out barrier options may also have multiple barrier level, with each barrier attached to a predetermined date. In this case, the price of the underlying asset must fall below each barrier on its predefined date before the holder obtains the right to buy or sell the asset. In some cases, up-and-in barrier options may be settled in cash rather than through the purchase of underlying assets.
Up-and-out barrier option example 1:
An investor enters into an up-and-out barrier call option contract with the owner of 100 shares in a stock which has a 250-Swiss-franc listed price at the time that the contract is signed. The total value of the 100 shares is 2500 francs.
When creating the option, the investor and owner agree to a barrier level of 255 francs, a strike price of 252 francs, and a term of 10 trading days.
The investor pays the owner a premium of 1 franc for each share underlying the option – a total of 100 francs in option premiums.
By the end of the 10-day term, the price of the stock has climbed to 54.60 francs.
Because the stock’s price did not reach or exceed the barrier level of 55 francs, the option is in the money, which means the investor has the right to exercise their option to buy the shares at the pre-agreed strike price of 52 francs per share. After subtracting the 1-franc premium which the investor paid for each share underlying the option, the investor still profits from a 1.60-franc discount on each share’s market rate. Their total profit off the 100-share option is 160 francs.
Up-and-out barrier option example 2:
Using the up-and-out barrier option from the above example, if the price of the share were to climb to 255.04 Swiss francs within the 10-day term – crossing the barrier level – the option would be out of the money and the investor would not be able to exercise it. The investor would lose the 100 francs which they paid in premiums for the option. The premiums, in this case, make up the share owner’s profit. The possibility of profiting in this way provides the incentive for the owners of underlying assets to enter into options contracts.