What Is an Up-and-In Option?
Let me explain what an up-and-in option is. These are a type of exotic option that you can often find through specialized brokers for high-end clients in the over-the-counter (OTC) markets. The option comes with both a strike price and a barrier level. As the name indicates, if you're the buyer, you'll benefit once the price of the underlying asset rises high enough to reach—or knock into—the designated barrier price level. If that doesn't happen, the option simply expires worthless.
Key Takeaways
These are exotic options typically available to institutional investors on stocks or forex. They include both a strike price and a specified barrier level. Remember, an up-and-in option pays out when the underlying reaches the barrier price level before expiration.
How an Up-and-In Option Works
Up-and-in options fall under the category of exotic options known as barrier options. As exotic options, barrier options have more complex terms than your standard plain vanilla options. You should know that barrier options come in two main varieties: knock-in or knock-out. The payout differs based on the type. Some barrier options even include a rebate provision if the option can't be exercised.
Since exotic options are often traded in OTC markets, there's quite a bit of variation in how they're offered. Depending on the liquidity of the underlying—whether it's forex or stocks—some might be customized. These aren't usually available to retail investors like you or me. Let me break down how the payouts work between the varieties.
Knock-In Options
Knock-in options can be up-and-in or down-and-in, depending on whether the price needs to rise or fall to hit the barrier. When the barrier price is crossed, the option becomes available for exercise. For an up-and-in option, you get the right to exercise when the barrier level is reached or exceeded, based on how it's structured.
In a down-and-in option, you gain the right to exercise when the underlying asset’s price drops to or below the barrier. These are structured as puts or calls. An up-and-in call lets you benefit from a rising price, while a down-and-in put helps when the price is falling.
Knock-Out Options
Knock-out options are the flip side of knock-in options. They make the option invalid when the barrier price is reached, but it's valid as long as the barrier isn't hit. These can be up-and-out or down-and-out. With up-and-out, it becomes defective if the price reaches or exceeds the barrier, and down-and-out triggers when the price falls to or below it.
Rebate Barrier Options
Both knock-in and knock-out options can have a rebate provision, making them rebate barrier options. In these, you receive a rebate if the option isn't exercisable at expiration.
Barrier Option Provisions
Barrier options can be structured in different ways. They're American-style with flexible exercise dates. Some activate or deactivate exactly when the barrier is hit, while others need the price to pass through it. You might see modified touch provisions—some with one touch, others requiring multiple touches. They can even have two or more barriers.
I want to note that this information is presented without considering your specific investment objectives, risk tolerance, or financial situation, and it might not suit all investors. Investing carries risks, including the potential loss of principal.
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