Barrier option is a type of financial option where the option to exercise depends on the underlying crossing or reaching a given barrier level. Barrier options are always cheaper than a similar option without barrier. Barrier options were created to provide the insurance value of an option without charging as much premium.[citation needed] For example, if you believe that IBM will go up this year, but are willing to bet that it won't go above $100, then you can buy the barrier and pay less premium than the vanilla option.

Barrier options are path-dependent exotics that are similar in some ways to ordinary options. There are put and call, as well as European and American varieties. But they become activated or, on the contrary, null and void only if the underlier reaches a predetermined level (barrier).

"In" options start their lives worthless and only become active in the event a predetermined knock-in barrier price is breached. "Out" options start their lives active and become null and void in the event a certain knock-out barrier price is breached.

In either case, if the option expires inactive, then there may be a cash rebate paid out. This could be nothing, in which case the option ends up worthless, or it could be some fraction of the premium.

The four main types of barrier options are:

Up-and-out: spot price starts below the barrier level and has to move up for the option to be knocked out.

Down-and-out: spot price starts above the barrier level and has to move down for the option to become null and void.

Up-and-in: spot price starts below the barrier level and has to move up for the option to become activated.

Down-and-in: spot price starts above the barrier level and has to move down for the option to become activated.

For example, a European call option may be written on an underlying with spot price of $100, and a knockout barrier of $120. This option behaves in every way like a vanilla European call, except if the spot price ever moves above $120, the option "knocks out" and the contract is null and void. Note that the option does not reactivate if the spot price falls below $120 again. Once it is out, it's out for good.

In-out parity is the barrier option's answer to put-call parity. If we combine one "in" option and one "out" barrier option with the same strikes and expirations, we get the price of a vanilla option: C = Cin + Cout. A simple arbitrage argument—simultaneously holding the "in" and the "out" option guarantees that one and only one of the two will pay off. The argument only works for European options without rebate.