What is a Forward Start Option? Definition, How it Works, Types, and Examples
AN
Summary:
A forward start option is a specialized financial instrument that differs from traditional options in its activation timing and strike price determination. This article explores the intricacies of forward start options, including their structure, valuation, and real-world applications.
What is a forward start option?
A forward start option is a derivative contract that resembles standard options but operates with a deferred activation and an undetermined strike price at the time of purchase. Unlike standard options, which are immediately active upon purchase, forward start options become active at a later specified date.
Understanding forward start options
When initiating a forward start option, all parameters are defined except for the strike price. Factors such as expiration date, underlying asset, contract size, and activation date are predetermined. However, the strike price is determined at a later point, often specified to be at or near the money concerning the current market price of the underlying asset.
The pricing of forward start options involves assessing anticipated future market conditions and negotiating terms based on risk preferences. This customized approach allows parties to tailor the option to their specific needs and market expectations.
Valuation and expiration
Once a forward start option becomes active and the strike price is determined, its valuation aligns with that of a standard option. If the underlying asset’s price at expiration is favorable, the option holder may choose to exercise it to realize gains or sell it if it is profitable.
Cliquets, also known as ratchet options, consist of consecutive forward start options where each subsequent option becomes active upon the previous one’s expiration. This structure provides ongoing opportunities to capitalize on market movements.
Example of a forward start option
Consider two parties entering into a forward start option agreement on Netflix Inc. stock. They agree that the option will become active on Jan. 1 at the current market price, with an expiration in June. Despite the unknown strike price, they negotiate terms based on anticipated volatility and market conditions.
If, upon activation, the stock price exceeds the strike price plus the premium, the option holder can profit by either selling the option or exercising it to obtain the underlying asset at a favorable price. Conversely, if the option expires out of the money, the premium paid upfront is lost.
Frequently asked questions
How are forward start options different from standard options?
Forward start options differ from standard options in their activation timing and strike price determination. While standard options are immediately active with a predetermined strike price, forward start options become active at a later specified date with an undetermined strike price.
What factors influence the pricing of forward start options?
The pricing of forward start options is influenced by factors such as anticipated future market conditions, volatility, and negotiated terms between the parties involved. These factors help determine the option’s premium and strike price.
What is the purpose of cliquet options in relation to forward start options?
Cliquets, or ratchet options, consist of consecutive forward start options where each subsequent option becomes active upon the previous one’s expiration. This structure provides ongoing opportunities to capitalize on market movements and manage risk effectively.
Key takeaways
- A forward start option operates with a deferred activation and an undetermined strike price at the time of purchase.
- Valuation of forward start options involves assessing anticipated future market conditions and negotiating terms based on risk preferences.
- Cliquets, or ratchet options, provide ongoing opportunities to capitalize on market movements by consisting of consecutive forward start options.
Share this post: