What it means
A standard option gives the holder the right to buy or sell an asset at a fixed strike price. A barrier option adds a condition based on the price of the asset.
An up-and-in option is a knock-in option, which means it is switched on only when the price crosses a barrier above the starting price. Up-and-in options can be calls or puts.
An up-and-in call lets the holder buy at the strike price, but only after the asset has traded at or above the barrier at some point. If the price never reaches the barrier, the option expires worthless, even if the asset ends the period above the strike price.
Because the payoff depends on the barrier being touched, the premium (the price paid for the option) is lower than for an equivalent standard option. The buyer accepts the chance of getting nothing in exchange for a lower cost.
The size of the discount depends on how close the barrier is and how volatile the asset is. Companies and investors use barrier options to tailor hedges and bets.
A buyer who expects a strong rally may prefer an up-and-in call because it costs less than an ordinary call, while a seller can earn a premium and has a lower chance of paying out. The risk is that the price rises to the barrier, activating the option, and then falls back.
Pricing needs specialised models and is usually handled by banks. Barrier options also create hedging challenges for dealers when the price is near the barrier, because the option's value can change sharply.
Users should understand the exact terms, including how the barrier is monitored.
In practice
Real-world examples.
Example
An investor expects a pharmaceutical company's share price to jump if a trial succeeds. She buys an up-and-in call with the barrier set above the current price. The option costs less than a standard call, and she accepts that it pays only if the shares rally strongly.
Example
A corporate treasurer is worried that the price of a raw material may spike. He buys an up-and-in call on the commodity with a barrier at a level he considers dangerous. The cover costs less, and it begins to protect him only if prices rise that far.
Example
A bank sells an up-and-in put to a client who believes a currency will rally and then collapse. The put switches on only after the barrier is touched. The bank hedges the risk with a mix of spot and standard options.
Formula
Calculation
Payoff of an up-and-in call at expiry = maximum of (final price - strike, 0) if the barrier was touched; otherwise 0
Suppose an investor buys an up-and-in call on 1,000 shares with a strike of $100 and a barrier of $120. Assume the premium is $4 a share, so the cost is 4 x 1,000 = $4,000. In scenario A the share price rises to $122 during the period and finishes at $115. The barrier was touched, so payoff = (115 - 100) x 1,000 = $15,000, and net profit = 15,000 - 4,000 = $11,000. In scenario B the price never reaches $120 and finishes at $115. The option never activates, the payoff is $0, and the investor loses the $4,000 premium.Case study
Seen in the real world.
Falcon Metals is an illustrative, fictional company that buys copper each quarter. The finance director considered a standard call option costing $60,000 and an up-and-in call costing $35,000, with a barrier at a price that would hurt profits.
She chose the up-and-in call, saving 60,000 - 35,000 = $25,000 in premium. Copper then rose steadily past the barrier, which activated the option, and the company gained from the cover.
If prices had stayed below the barrier the option would have expired worthless, but the company would not have needed protection. The illustrative lesson is that an up-and-in option suits those who need cover only in an extreme scenario, but it needs to be matched to the actual risk.
Watch out
Common mistakes.
- Thinking the option pays out just because the price ends above the strike, when the barrier must have been touched first.
- Assuming that the cheaper premium means a better deal, when the discount reflects the real chance of receiving nothing.
- Ignoring how the barrier is monitored, as terms may specify continuous watching or only closing prices on certain dates.
Questions
People also ask.
What does knock-in mean?
It means the option starts to exist only when the barrier condition is met, in contrast to knock-out options that cease to exist when it is met.
Why is an up-and-in option cheaper than a standard option?
Because there are price paths in which the standard option would pay out but the up-and-in option does not.
Who typically trades these?
Banks, corporate treasurers and sophisticated investors use them, normally over the counter and not on exchanges.
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