An exercisable or knock-in barrier option is an option that does not exist from inception, though a premium is paid up-front to the seller. The option is exercised, created or ‘in’ when the underlying asset reaches a certain predetermined level or barrier. This event can happen any time throughout the life of the option.
There are two main types of knock in options:
- The up and in put
- The down and in call
The up and in put
This is a simple European put which is exercised (gets knocked in) if, at any time during the life of the option the underlying asset reaches the barrier or in point. It is, in essence, the inverse of the up and out put. The holder of this asset owns an option with a payoff at expiration of zero unless at some time during the life of the put option the underlying asset rises above the barrier level. If it does, then the holder’s asset becomes a simple European put and has a payoff accordingly at expiration.
For example, a soybean producer wishes to secure today’s higher prices caused by the Midwest flooding. He could sell his inventory forward or purchase a European put option on the crop. Both will protect against a downward move in the price but only the European option will allow him to benefit from higher prices. Since he would like some flexibility with future higher prices, he could purchase a three month at the money European put option (with soybeans trading at $5.00 a bushel), but is discouraged by the high premiums. Instead he could purchase an up and in put with a barrier at $5.25 for 35% less premium. The producer now owns a European put struck at $5.00 that does not exist until $5.25 is reached. Once reached, the producer is able to lock in the prices at more favorable levels.
As in previous examples, the seller may lose in fast moving whipsaw markets. In addition, the producer is not hedged if prices decline without the barrier being activated. However, this option strategy reflects his market opinion in the cheapest and most flexible manner possible.
The second major type of knock-in barrier is the down and in call.
The down and in call
In the same way that an up and in put gets exercised if the barrier is reached, a down and in call is a simple European call which exercises if the underlying asset falls below the barrier or in level. That is, until the option maturity date, the option does not exist (though a premium is paid up-front) until the barrier is breached. The exercise or barrier level entitles the holder to purchase the European call and hold it until expiration.
Assume you are speculating in silver. You are aware that major support in the active contract is $4.00 with the active contract now trading at $4.25.If this level holds, then substantial upside exists. If it fails, the market would collapse. You could purchase 3-month European calls struck at $4.25 and wait for a test of support. Alternatively, you could purchase a down and in call with the terms above, but with a barrier of $4.00 for 31% less premium.
If silver hit the barrier, then the $4.2 European call would be exercised. In the event the market fell through this level, the call could be liquidated for a small loss. In any down move market in which the barrier is hit this is a superior product to the conventional European option. Any up moves or moves in which the barrier is not hit precludes the buyer benefiting in the underlying asset rise. The drawback is minor as the speculator is short-term bearish but long-term bullish but wants an option that will reflect his market view as cheaply as possible.
In summary, it can easily be seen that these relatively new types of exotic products are basically variations of the standard option. The real challenge is the attempt by the bank dealer to lower the option cost by introducing a small risk element to the buyer.