It’s an all-or-nothing idea that either pays off under predefined circumstances or expires worthless.

There are two triggers, an upper and a lower price of the underlying asset. If the underlying price hits or exceeds one of these triggers, the option will expire worthless or become a valid instrument (depending on whether it is a knock-in or knock-out contract). For comparison, the individual barrier only defines an upper or a lower barrier, so that the underlying movement in the opposite direction does not trigger an event (knock-in or knock-out).

Traders can view the double barrier option in two ways. Either it is a complex contract with two elements (upper and lower) or a combination of two barrier options that exist in the same contract. If it is a knock-in, it is speculated that the underlying price will move enough to make a profit, like a long straddle. When there is a knock-out, the hope is that the underlying price will stay within the price range between the barriers and this is like a short straddle. The difference is crucial. In a straddle, either side can be closed or rolled. With the double barrier option, the two sides cannot be separated or closed before expiration. The option itself only arises if the price level is exceeded (knock-in) or expires automatically if these barriers are not exceeded (knock-out).

However, this contract is not really a combination of two knock-in or knock-out options. If it were, a breach of either barrier would leave the other side in place. Since it is a single contract, the two obstacles are linked and cannot be separated.

Three things Boost the prices and value of a double barrier option. First is the duration. The longer the time to expire, the higher the risk of breach and the cheaper the option. Second is money. The closer the price is to the barrier on either side, the more likely a breach is and the cheaper the option. Third is volatility. The higher the volatility, the cheaper the option due to the higher likelihood of a breach.

These three factors work against the vanilla option. Longer time, tighter sum of money, and higher volatility usually define a higher option price, not a lower one. This opposite attribute makes the barrier option particularly interesting and opens up many possibilities. For example, a double barrier could be used as a hedge against vanilla options since the causes of valuation changes are opposite to vanilla contracts. However, this becomes complex and potentially costly. Most traders may find the potential to hedge options interesting but impractical.

Another feature of the double barrier option is that it doesn’t matter what happens after the price barrier is breached. The expired knock-out cannot be brought back to life even if the price withdraws, and a knock-in remains regardless of how the price behaves after one of the barriers has been reached. This observation has further consequences depending on whether the double barrier is set up based on calls or puts.

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The reason for opening a barrier option is usually based on the desire to hedge portfolio positions. Hedging with double barriers is cheaper than hedging with spreads or straddles (or a combination of both). The lower cost makes sense because of the built-in limitations of the double barrier contract. The main disadvantage is the European style draining. With vanilla options and American style, positions can be closed at any time, either with small gains or with minimization of losses. In this regard, hedging with vanilla options is more expensive, but also more flexible.

The limited risk of double barrier options makes them attractive for hedging, in some cases even more so than using higher risk, more expensive vanilla options. The barrier option can best track a trader’s beliefs regarding future underlying price movements. This belief probably relates to the degree of movement, not just direction. The double barrier eliminates risks associated with the volatility of some products such as exchange rates.

Despite the advantages of hedging with double barrier options, clear risks and disadvantages must be considered for both buyers and sellers in the hedging universe. The buyer of a double barrier option can lose the entire position caused by the expiry if the barrier experiences a rise in price. The seller must face significant hedging problems if the underlying is close to the barrier price. One solution to these potential risks is a development proposal Step optionsthat involve an incremental payback based on the degree of movement past the barrier.

However, for hedging purposes, attempting to mitigate losses is against the core concept itself. The purpose of hedging is to minimize the risk at the expense of the potential loss of the entire value of the hedging instrument (in this case the double barrier option). While it makes sense to try to mitigate the risk, this also raises the question of whether a trader dealing with losses should even use double barrier options. It might make more sense to rely on vanilla spreads and straddles and just get the hedge and live with the possibility of a loss. Since these can be closed or rolled at any time (under American assumption), the hedging risk can be controlled to a certain extent.

Even more complex options that go beyond the step have been suggested in the academic literature. These ideas include proportional double step options and delayed double barriers. Most traders will find these variations too complex to offer a practical alternative form of coverage and are more likely to resort to vanilla coverage than investigate the alternatives. [Davydov, Dmitry and Linetsky, Vadim. (Winter 2001/2002) “Structuring, pricing and hedging double-barrier step options,” Journal of Computational Finance, Volume 5, Number 2]

Michael C. Thomsett is a widely published author with over 80 business and investment books, including the best-selling Get started with options coming in its 10th edition later this year. He also wrote the recently published The math of options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Publishing as well as Seeking Alpha, LinkedIn, Twitter and Facebook.

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