An up-and-in barrier option is a type of option which gives its holder the right to buy or sell an underlying asset if the price of the underlying asset matches or exceeds a predefined barrier level (the knock-in price) over the option’s lifetime.
Up-and-in barrier options are dormant from the time they are created until the price of the underlying asset reaches or exceeds the barrier level. Only then do they become active, allowing their holder to exercise them. If the underlying rate does not reach or exceed the barrier level within the option’s lifetime, the option remains dormant and becomes worthless.
This type of option is used by investors who believe that the value of a specific asset will increase within a specific time frame.
When creating an up-and-in barrier option agreement, both parties to the contract agree to a strike price. This is the price at which the option holder has the right to purchase the underlying assets if their market rate reaches the barrier level – resulting in the option being in the money. In some cases, an owner of underlying assets may settle with a holder of options which are in the money in cash rather than selling them the underlying asset. This allows the option holder to profit while avoiding costs and taxes attached to transferring the ownership of the underlying assets and then selling them.
The buyer of an option pays the owner of the underlying assets a premium for the option. If the underlying rate does not match or exceed the strike price within the option term, the option is out of the money – meaning it becomes invalid. In this case, the option holder makes a loss equal to the premium which they paid for the option.
Up-and-in barrier option example 1:
An investor enters into an up-and-in barrier call option contract with the owner of 10,000 shares in a stock which – at the time that the option is created - is listed at 50 Swiss francs per share. The total going value of the 10,000 shares is 500,000 francs.
The option has a barrier level of 51 francs and a strike price of 50.50 francs. The option term is 7 days.
The owner of the shares charges the investor a premium of 0.20 francs per underlying share – a total premium of 2000 francs for the option.
By the end of the 7-day term, the market price of the stock has increased to 51.90 francs.
Because the stock’s price exceeded the 51-franc barrier level, the option is in the money. This means the investor has the right to exercise the option and buy the underlying shares at the pre-agreed strike price of 50.50 francs per share – or 505,000 francs in total. The investor than resells the shares at the going rate of 51.90 francs each – or 519,000 francs in total. After subtracting the 2000-franc option premium from their profit, the investor earns a profit of 12,000 francs.
Up-and-in barrier option example 2:
Using the up-and-out barrier option from the above example, if the underlying stock’s rate did not reach or exceed the 51-franc barrier level within the 7-day term, the option would become worthless and the investor would lose the 2000-franc premium which they paid for the option. In this case, the share owner would profit by pocketing the option premium.
More on this topic:
Interactive stock broker comparison
Up-and-out barrier option
Down-and-out barrier option
Down-and-in barrier option
