This post is published by Hamish Raw of https://hamishraw.com/
Knock in binary options require that a barrier(B) be hit for the ‘knock-in’ to convert into a binary call, binary put, one-touch binary call or one-touch binary put. If the barrier is not hit by expiry the strategy settles at zero.
So, if one were long the down and in binary call then the underlying price needs to fall to the level of the barrier in order to trigger the barrier and the holder be rewarded with a binary call option.
There are six knock in binary options consisting of three down barriers and three up barriers, each defined by the relationship of the strike(K) to the barrier. The knock in binary options under review in this section are:
1. Down and In Binary Call 2. Up and In Binary Put
3. Up and In Binary Call 4. Down and In Binary Put
5. Down and In One-Touch Call 6. Up and In One-Touch Put
Yet again as with all barrier bets these strategies require a higher level of management as the underlying needs to be constantly monitored. Knock in binary options require close monitoring since the directional exposure changes at the barrier, i.e. a down and in call increases in value as the underlying falls towards the barrier, but on touching the barrier, the subsequent binary call option falls in value as the underlying continues to fall while if the underlying bounces off the barrier, then the binary call option increases in value. This feature will have specific implications for the market-maker who has sold the down and in binary call and has sold the underlying to delta-hedge for as soon as the underlying hits the barrier the market-maker will need to buy back the hedge but then purchase more of the underlying to hedge against the subsequent short call position which is now exposing the book to a rise in the underlying.
The above market-maker problem increases the attraction to the buyer of knock in binary options since if the barrier was set at a support or resistance level, then the underlying may bounce aggressively off the support or resistance before a long or short position could be established.