Forward start options are purchased in the present, but have a strike that is determined afterwards (i.e. at the forward date) but before maturity. At the forward date, the option becomes a standard European option. The option is initially usually at-the-money, or at some fraction above or below the spot price.
Executive compensation plans often use the future company share price is a key performance benchmark. An executive may receive a forward start call on the company’s stock price that is initially at-the-money. The option starts at a later date (with the strike determined at that date) after the trend of the stock price is established.
Cliquet (or ratchet) options consist of a standard option that starts immediately, followed by a series of consecutive forward start options. Each option starts with an at-the-money strike. This allows the holder to lock in profits over the lifetime of the option.
Price Forward Start Options in Excel
Forward start options are defined by the following equations, given by Rubinstein (1991).
- c and p are the price of European calls and puts respectively
- r is the risk-free rate
- T is the time to maturity
- t is the time to start
- σ is the asset volatility
- N is the cumulative normal distribution
- D is the dividend
- S is the spot price
- α is a constant (the strike price equal to α S)