Double Barrier Option: What it Means, How it Works, Types

What Is Double Barrier Option?

A double barrier option is a type of binary, or digital option, that involves both an upper and lower trigger price placed on the underlying asset.

Understanding Double Barrier Option

A double barrier option will only activate if the price of the underlying touches or closes beyond either trigger level, called the barriers. If either barrier price is touched, the option either becomes valid or invalid, depending on whether it is a knock-in or knock-out type.

In comparison, single barrier options use only an upper or a lower barrier, so a move in the opposite direction would not trigger a knock-in or knock-out event. Barrier options can be constructed as either puts or calls.

Considered an exotic option, a double barrier option is a combination of two single barrier options, with one barrier above and one barrier below the current price of the underlying. It is a bet by the holder that the underlying asset will move significantly, in the case of a knock-in barrier option, or will move by a very small amount, in the case of a knock-out barrier option, over the life of the contract.

Traders use these options when they have an opinion on volatility but not on the direction of the underlying asset's next price move. A barrier option is a type of option where the payoff and the very existence of the option depend on whether or not the underlying asset reaches a predetermined price.

Large institutions or market makers create these options by direct agreement for the primary reason that valuing them is a complex undertaking. For example, a portfolio manager can use them as a less expensive method to hedge against potential losses on a long position. The hedge would be less costly than buying vanilla put options. However, it would be imperfect since the buyer would be unprotected if the security price decreased below the barrier price.

Pricing depends on all regular options metrics with the knock-in or knock-out features adding an extra dimension. European-style allows the exercise of an option only at the expiration date. An American-style option allows the holder to exercise the option at any time on or before expiration.

Knock-In and Knock-Out

A knock-in barrier option becomes valid when the underlying exceeds the barrier. It then acts as any other options contract. A knock-in option has no value until the underlying reaches the barrier price. The critical concept is if the underlying asset reaches the barrier at any time during the option's life, the knock-in option is brought into active existence and will remain that way until expiration. It does not matter if the underlying moves back above, or below, the barrier afterwards.

A knock-out barrier option becomes invalid, or ceases to exist, when the underlying touches the barrier. Thus, it becomes worthless at that point. It doesn't matter what the underlying price does afterwards.

Other Types of Barrier Options

Barrier options come in single and double barrier varieties, as covered above. Single barrier options come in four varieties: down-and-in, down-and-out, up-and-in, and up-and-out, covering all possibilities of single barrier and the knocking feature.

However, there are several others, including binary options, which pay a set amount if a barrier is reached or zero if it is not reached.