A “Barrier Option”, is a type of derivative where the payoff depends on whether or not the underlying asset has reached or exceeded a predetermined price. A knock-out barrier option expires worthless if the underlying exceeds a certain price, limiting profits for the holder and limiting losses for the writer. A knock-in barrier option has no value until the underlying reaches a certain price.Barrier options are often used to protect against large losses in times of market volatility. For example, if an investor owns shares in Company X and is worried that they will lose value during times of market stress, they might purchase a put option as insurance. The put would be at-the-money if Company X's stock falls below its current price, meaning that it would give the holder rights to sell their shares at today's prices even if they fall in value later on. However, because puts become more expensive as volatility increases (due to their higher probability of being exercised), an investor might also purchase a knock-out put which would only be valuable if Company X's stock falls below a certain point. This way, they know their downside protection is limited should volatility increase even further.
