What Is a down-And-In Option?

Mary McMahon
Mary McMahon

A down-and-in option becomes active if the price of the underlying security falls below a certain point during the term of the contract. When this event occurs, the investor can decide to exercise the option. If it never falls below the preset barrier, the option loses all value. Such options are an example of a financial derivative product. They tend to be less expensive than so-called “vanilla options” which have straightforward contracts.

Man climbing a rope
Man climbing a rope

This is a member of a family of financial instruments called barrier options, because they are all contingent on pricing passing an agreed-upon barrier. Up options involve pricing that moves above a barrier, while down options require the price to fall below this level. In options become active when the barrier is hit, while out options are canceled when the pricing reaches the barrier point.

With a down-and-in option, the value of the underlying security drops below the barrier, and the option becomes active. The investor holding the option can choose to exercise it, taking advantage of the drop in price. This allows investors to take positions which will allow them to use changing market conditions effectively, while reducing their exposure to risk. The down-and-in option can be structured as a put or call option, allowing the investor the right to sell or buy the underlying security when it matures.

Pricing on barrier options tends to be more favorable than that of vanilla options; someone who buys a basic call option to buy a security in the future, for example, would pay more than someone with a down-and-in call option for the same security. Exotic options like these provide more opportunities for investors, with less financial exposure at the time the contract is established. If the barrier is never reached, the down-and-in option will expire without ever being worth anything.

Trading in barrier options can be complex. Down-and-in option contracts are primarily used by experienced, skilled investors, often acting on behalf of a brokerage or institution. It is necessary to be familiar with the market and associated trends, the specific security involved in the transaction, and any limitations that might need to be considered with the purchase before executing a trade. Investors who are not familiar with a given market or exchange may get into trouble with exotic derivatives, especially since they are often traded in high volume, which creates a big exposure to financial risk if an investor makes a poor purchase.

Mary McMahon
Mary McMahon

Ever since she began contributing to the site several years ago, Mary has embraced the exciting challenge of being a wiseGEEK researcher and writer. Mary has a liberal arts degree from Goddard College and spends her free time reading, cooking, and exploring the great outdoors.

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