This post is published by Hamish Raw of https://hamishraw.com/
Barrier options in general provide efficient tools for chartists to deploy when they want to take a position based on a support or resistance level being touched, holding and bouncing back to a particular level. Knock-in one-touch options, as with knock-in binary calls and puts, can be extremely potent instruments providing the barrier is placed in a relevant position. Up and in one-touch put options provide the speculator with the opportunity to bet that the above resistance level will hold and subsequently, that at some time prior to expiry, the underlying will fall back to the strike price.
The examples used for this strategy are Bunds which at the time of writing are trading around 135.00 and have a 12% Implied volatility. Figure 1 illustrates an up and in one-touch put with barrier at 135.50 and strike at 134.00. The knock-in profile (black) shows the Bunds must rise to touch the barrier at 135.50 at which point the strategy transforms into a one-touch put option (red) with strike at 134.00. If the Bunds do not touch the barrier by expiry the strategy settles at zero.
The knock-in and the one-touch put profiles intersect at the barrier. If the barrier is pitched at a major level of resistance it provides a compelling instrument for chartists to back their view that the level will hold and the underlying fall back off it. In this instance the chartist is invited to speculate on whether Bunds rise to 135.50 and then fall 150 ticks to hit the strike at 134.00.
Up and in one-touch puts with 2, 8 and 25 days to expiry and 10% implied volatility is on offer in Figure 2. With 8 days to expiry the knock-in at 134.00 is worth 13.31 offering a return of just over 650% should the Bunds rise to 135.50 and then fall back 150 ticks. At the barrier the knock-in is worth 45.46 with 8 days to expiry and with just 2-days to expiry the knock-in at the barrier is worth 13.36, pretty much unchanged from the entry level of 13.31.
The attraction of this strategy to the chartist who believes that the Bunds 135.50 level is a critical resistance level is the return on offer accorded by the conditional probability nature of the strategy.
Figure 3 illustrates the same up and in one-touch put option but over a range of implied volatilities, the time to expiry fixed at 5 days. An out-of-the-money one-touch put nearly always1 has positive vega meaning that an increase in volatility increases the value of the one-touch put which in turn demands an increase in value of the knock-in which has to intercept the one-touch put at the barrier; the barrier also has a greater chance of being touched with higher volatility. This can be contrasted with the down and out one-touch call where a higher volatility increases the chance of the one-touch call being knocked-out and settling at zero.
The advantages to the chartist are:
- Back the resistance level with a minimum risk strategy. Often resistance levels, as support levels, are pivotal points from which the underlying may move from aggressively in either direction so waiting for the barrier to be touched and then going short futures could be highly risky if there is a break-out.
- Alternatively, should the resistance level hold and Bunds fall quickly from it then selling at the barrier may be almost impossible. This strategy alleviates the need to
climb on board a collapsing market as the buyer of the knock-in has automatically received a short position in the market via his converted one-touch put.
- The market does not need to be monitored by the naked buyer of the strategy since the knock-in converts into the one-touch put automatically, and then on hitting the strike the bet is automatically settled at 100.
The above points outline the disadvantages of this bet to the market-maker:
- On triggering the barrier a market-maker short this strategy needs to sell double the short underlying position being held already as a hedge in the rising market. If the market bounces aggressively bounces off the barrier then selling the hedge and then selling more for the now naked short one-touch put position could be extremely difficult.
- But the silver lining to this particular cloud is if the underlying gaps up through the barrier on the open one morning. The position is now a short one-touch put which is getting cheaper; furthermore the market-maker is still long the hedge from below the barrier.
The knock-in component of the up and in one-touch put resembles a one-touch call with the pay-off adjusted so that instead of a winning price of 100, the one-touch price at the barrier equates to the one-touch put premium. It is not so. The knock-in is graphically displayed in Figure 4 alongside the one-touch call with barrier/strike at 135.50 and there is a clear disparity.
In the Knock Out section with the down and out call where K<B then the profile is simple: since the strike is below the barrier then should the underlying not touch the barrier it will settle at 100, else 0. This is nothing less than 100 less than the One-Touch Put. More under down and out binary call options.
1 As implied volatility increases the vega falls to zero and should the implied volatility increase beyond this point the vega will turn negative as the strike constrains the option value to 100. Increasing implied volatility subsequently has a disproportionate effect on the value of the binary call as the probability of the underlying falling further outweighs the impact of the underlying hitting the strike.