Forward Start Option: What it is, How it Works, Example

What Is a Forward Start Option?

A forward start option is an exotic option that is purchased and paid for now but becomes active later with a strike price determined at that time. The activation date, expiration date, and underlying asset are fixed at the time of purchase.

Understanding the Forward Start Option

At initiation, a forward start option contract spells out all the defined characteristics relevant to the option, except for its strike price. The expiration date, underlying asset, size, and activation date are set at the time the contract is drawn up.

The only unknown for the contract is the strike price. In terms of pricing the contract, the future price of the underlying asset is also unknown. The contract typically stipulates some parameters for where the strike price will be in relation to the underlying asset's price. For example, the people buying/selling the option could specify that the strike will be at the money (ATM) at activation, or 3% or 5% in the money (ITM) or out of the money (OTM). Since it is a customized contract, they can negotiate any terms they want.

Forward start options typically attempt to keep future strike prices ATM or near the money. In this way, the holder will have the right, but not the obligation, to buy (call) or sell (put) the underlying asset in the future at or near the then-current market price. Knowing where the strike price will be in relation to the underlying's price makes it easier to come up with the premium (cost) of the option, which is also typically determined and paid at the initiation of the contract prior to the activation date.

If, at the expiration date, the underlying trades below the strike price of the option (for a call), then it expires worthless. Conversely, if the underlying is above the strike (for a call), then the holder exercises it and owns the underlying at the strike price. For a put option, the opposite applies. If the underlying is below the strike price, the option has value and will be sold or exercised to realize a gain. If the underlying is above the strike price, the option will expire worthless.

Typically, as with most options, the holder may sell the option if it is ITM and take the cash instead of exercising the option. Since it is an exotic option, the seller and buyer of the option may also agree to settle the option with cash instead of delivering the underlying.

Cliquets

A group of consecutive forward start options is called a ratchet option or cliquet option. In this instance, the first forward start option is active immediately, and each successive forward start option becomes active when the previous one expires.

When the first option in the series matures, the next option becomes active as it gets its strike price. If at the end of the next settlement the underlying trades above the new strike (for a call), the holder may elect to receive the difference between the price of the underlying and the strike, or exercise the option and receive the underlying.

Example of a Forward Start Option

Forward start options are exotic and therefore customized by the people who trade them. Since they are not listed on an exchange, a hypothetical example is required for demonstration purposes.

Assume that two parties agree to enter into a call forward start option on Netflix Inc. stock. It is September and they agree that the forward start option will activate on Jan. 1 ATM. That means on Jan. 1, the strike price for the option will be the price that Netflix stock is trading at on that day. The option will expire in June.

The exact strike price is unknown, but the parties do know the strike and underlying's price will be the same at activation. They can look at current six-month options (January to June) and assess volatility to determine a premium for the option.

In the end, they agree to trade one contract, equivalent to 100 shares of the underlying stock, on a premium of $40, or $4,000 for the contract ($40 x 100 shares). The call buyer agrees to pay the $4,000 now (September), even though the option doesn't activate till January.

On Jan. 1, assume the stock price is $400. The strike is set at $400, and the option is now a vanilla option with a June expiry.

At the June expiry, assume Netflix is trading at $420. In this case, the option is worth $20 ($420 - $400 strike). If they settle in cash, the buyer receives $2,000. Alternatively, if they exercise, they receive 100 shares at $400 and can keep them, or sell them at $420 to make $2,000. Notice that this still results in a loss for the buyer, since they paid $4,000 but are only receiving back $2,000.

To make money on the call, the price of the underlying needs to move above the strike price plus the premium. This can be thought of as the breakeven price. Therefore, if the price moves up to $450 by expiration, the option is worth $50 ($450 - $400 strike), and the buyer receives $5,000. That's a net profit of $1,000 over their $4,000 cost.

If, on the other hand, the underlying is trading below the $400 strike at expiry, the call option expires worthless and the buyer's premium is lost, resulting in a $4,000 profit to the seller.

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