Bermuda Option, Forward Start Option, Barrier Option

Bermuda Option

A bermuda option is derivative instrument where the holder of the option has the right, but not the obligation, to exercise his option only on certain predefined dates occurring in regular intervals throughout the duration of the contract. The bermuda option is a hybrid of an american option, where the holder is entitled to exercise at any point for the contract duration, and a european option, where the holder may only exercise his right at the point of expiry. The bermuda option gets its name from the fact that Bermuda lies geographically between the United States and Europe. Bermuda option contracts can either be a put or call type. Bermuda option contracts are less common than their American and European cousins. Further, bermuda option contracts are generally traded over the counter. A bermuda option can apply to a variety of underlying assets, however, this option type tends to be most frequently used with Forex and interest rate contracts (e.g. bermuda swaption).

Forward Start Option

What is it?

• An option that will start some time in the future, where the strike price is not fully determined until an intermediate date t before maturity T.

How is it constructed?

• It can be constructed as a call or a put, and can be either European or American.
• On the start date, the strike is typically the prevailing spot price (ATM), or is set to a proportion of the underlying asset price at the time of determination.
• The premium is paid at time zero.

When is it used?

• Enables investors to monetise growth in dividends without taking market risk.
• They are the building blocks to cliquet options.

What are the benefits?

• Cost is known although the option comes into existence only in the future.
• Maximum loss is the premium paid.

Barrier Option

Barrier options are similar to standard stock options, although there are vital differences.

Where a standard call option or put option have a payoff that only depends on whether the strike price has been exceeded or not, a barrier option’s payoff depends on two price levels: the strike price and the so-called barrier price.

Investors use barrier options to enhance returns from or gain exposure to future market scenarios that are more complicated that the simple bearish or bullish expectations that form part of an ordinary vanilla option. Books can (and have been) written about barrier options, so this is only intended as an introduction to the subject.

Types of barrier options

The two most common types of barrier options are knock-in and knock-out barrier options.

Knock-In barrier options

With this type of barrier option, the option only comes into life if the knock-in price is exceeded. It can therefore expire worthless even if it is trading beyond the strike price at expiration.

Example:

Shares of company ABC are currently trading at $100. A trader buys knock-in barrier
call options on these shares with a strike price of $110 and a knock-in barrier of $120. At expiration date the shares are trading at $115. The options expire worthless, since although the strike price has been exceeded, the underlying price never traded above the knock-in barrier of $120.

Knock-out Barrier Options

This type of barrier option becomes worthless if the knock-out barrier is exceeded.

Example:

Shares of company ABC are currently trading at $100. A trader buys knock-in barrier call
options on these shares with a strike price of $110 and a knock-out barrier of $120. At expiration the shares are trading at $125. Once again the options expire worthless, since although the underlying share price is above the strike price, the options became worthless the moment the share price crossed $120.

More types of barrier options

The two types of barrier options described above are up-and-in (first example) and up-and-out (second example). Their put counterparts are found in the so-called down-and-in and down- and-out put barrier options.

A down-and-in barrier option only becomes activated when the underlying price crosses the barrier price, similar to the first example above, with the difference that here the strike price and barrier price are both below the current price of the underlying asset.

A down-and-out barrier option becomes worthless the moment the price of the underlying asset trades below the barrier price. This is similar to the second example above, with the difference that the option only loses its value if the price of the underling starts trading below the barrier price.

Benefits and disadvantages of barrier options

Barrier Options are used by professional traders because:

a) They are generally speaking cheaper than conventional vanilla options and
b) They therefore allow for a bigger percentage profit on the investment if the trade
works out

Disadvantages of barrier options

The biggest single disadvantage of barrier options is that, because more conditions have to be met before the option expires In The Money, the probability of loss is bigger than with an ordinary vanilla option.