Barrier options are only available via institutions to sophisticated traders and are effectively options that only trigger to become active once a price (barrier) is reached on the underlying security or cease to exist when a price is reached on the underlying security.  Barrier options are available either as knock-in (becoming active after a trigger) or knock-out options (ceasing to exist after a trigger). 

Even if not trading them, it can be helpful to be aware of barrier options because the underperformance of implied volatility can sometimes be explained by institutions being more attracted to the lower price and higher leverage (size) of exotics, such as barrier options.

Professional: Understanding Barrier Options

A knock-in barrier call must go above a certain price before the call goes into effect. As Colin Bennett describes in Trading Volatility, “The payout of a barrier option knocks in or out depending on whether a barrier is hit” (2014, p. 134). This extra challenge is what makes them more affordable. 

For example, a call strike price might be at 100 but then the knock-in price is at 120. For the knock-in call to go into play, it must first clear the bar of the underlying security hitting 120. Once that happens, the knock-in call becomes activated at 100 which at that point would be 20 points ITM. Unlike a normal call which can be closed early for a profit even if it is OTM, using a knock-in call greatly increases the chances of it expiring worthless which is why it costs less. However, as some compensation, barrier options can come with rebates as minor payoff if it expires worthless. Strategically, a knock-in option would be a good fit for a portfolio manager if they would plan on holding an option even if it went deep ITM, as opposed to taking quick profits on it.

A knock-out barrier call, being the other type of barrier option, takes away one of the most important advantages of an option, which is that it functions like a stop loss but cannot shake the trader out of the position. A knock-out option will expire immediately if it moves beyond the barrier price, while a normal option would just experience a sharp drop in value but still be in play. But like a knock-in option, in some cases knock-out options also have a rebate as a consolation prize. Institutional traders will often gladly accept the cheaper premium for these barrier options compared to normal vanilla options–on the thesis that it is too unlikely the barrier would be breached.

ITM (in the money): An option is in-the-money if it would still have some [intrinsic] value if the option expired with the underlying price where it currently is. Being in the money is entirely about the strike price beating the underlying price. ITM options cost more than options at or out of the money; they also have less extrinsic value. Additionally, ITM options have more deltas (immediate directional risk).

IV (implied volatility): The expected percentage range over a year with 68.3% confidence. This is based on options pricing at one standard deviation. Long options benefit from increases in implied volatility and short options benefit from decreases in implied volatility. In general, when implied volatility increases it means that the expected percentage range is getting larger. When implied volatility is applied to lengths of time other than one year, then this is called the expected move.

leverage: One of the main uses of options is the leverage which comes with it. Buying options provides you with a position that has defined and limited risk with a higher total reward when correct, but you have to be right with timing. By paying a specified premium, long options on stocks have a defined loss that is less than if you purchased the equivalent amount of underlying stock. Additionally, all long options, whether puts or calls, have amplified profits when you are correct by having a multiplier effect in terms of number of shares being traded and being long gamma. In exchange for that protected and enhanced leverage, option holders are willing to take on some time decay.  This means their timing for the expected underlying stock price move must be right or they can lose the entirety of their investment.

OTM: An option is out-of-the-money if it would have zero value expiring with the underlying at its current price. When an option is out-of-the-money, its entire price is made of extrinsic value, which is a premium that option buyers are willing to pay for an opportunity to make a profit.

security: Any investment product that can be traded on an exchange, such as but not limited to stocks, futures, ETFs, options, bonds, mutual funds, and treasuries. 

underlying: A reference to the immediate price of the underlying security. This is also sometimes called spot (the spot price of the underlying). The spot price is in contrast to derivatives which have option prices or [forward] futures prices.