What are the main types of barrier options and how do knock-in vs knock-out structures work?

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AcadiFi · Accepted Answer

A barrier option either comes into existence (knock-in) or ceases to exist (knock-out) when the underlying touches a specified barrier level during the option's life. Combined with whether the barrier is above (up) or below (down) the initial spot, you get four types: up-and-in, up-and-out, down-and-in, down-and-out. Consider a hypothetical trade by Marcus Delacroix at Crescent Ridge Capital. He buys a down-and-out call on shares of Vorath Industries trading at 82 dollars, strike 85, barrier 70. If Vorath ever trades at or below 70 before expiry, the call is knocked out and worthless regardless of where it closes. The premium is cheaper than a vanilla call precisely because of this contingency. A down-and-in call only activates once the price touches 70. Paradoxically, an investor bullish long-term but expecting a dip might prefer this cheaper structure. ```mermaid flowchart LR S[Spot at 82] --> U{Barrier Type?} U --> UO[Up-and-Out
dies if up] U --> UI[Up-and-In
born if up] U --> DO[Down-and-Out
dies if down] U --> DI[Down-and-In
born if down] ``` Barrier monitoring can be continuous, discrete, or at specific windows — this affects pricing materially.

What are the main types of barrier options and how do knock-in vs knock-out structures work?

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