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A double barrier option is a type of financial derivative based on a normal options contract in which one party has the right to complete an agreed deal under agreed terms on an agreed future date. With a double barrier option, there are consequences if the price of the underlying asset reaches a set level before the option comes due. Usually the consequence is either that the deal is automatically and immediately completed, or that the entire agreement is canceled.
A simple option is a derivative, meaning it derives its value from an underlying asset such as stock in a particular company. The option involves party A paying party B a negotiated amount of cash now to agree the right but not the obligation to buy a set amount of the stock from party B at a fixed price on a future date. Whether A chooses to exercise the option will depend on the actual market price of the stock on this date and thus whether she can buy the stock and immediately sell at a profit.
With a double barrier option, there are two trigger prices. If the market price of the underlying asset reaches one of these trigger prices before the option comes due, a specific outcome is triggered. As an example, imagine the two parties have agreed upon an option involving a stock with the current market price of $1.50 US Dollars (USD), with the option being for A to buy the stock from B at $1.75 USD in three months' time.
The first trigger price is known as a knock-in price, meaning party A gains a new option if this price is reached. In the example, there could be a knock-in price of $2 USD triggering an immediate option of $1.85 USD. This means that if the stock price hits $2 USD before the three months is up, party A has the choice of immediately buying at $1.85 USD, or waiting until the three months is up to buy at $1.75 USD, thus hoping the market price remains high.
The second trigger price is known as a knock-out price, meaning the deal immediately ends. In the example, the knock-out price could be $1.25 USD, meaning that if the stock falls this low, the deal is canceled immediately. Depending on the terms of the agreement, party B may have to return the payment party A made to set up the deal.
Depending on the specific prices, it is possible for both the knock-out and knock-in prices in a double barrier option to favor one party over the other, for example by limiting risk. Alternatively the knock-out could favor one party and the knock-in could favor the other. This added complexity can alter both the price party A pays to party B to set up the deal, as well as the price party A will demand if she trades her position in the deal to a third party before the option comes due.