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A forward start option is a type of futures or stock options contract used in investing where the investor purchases a trading contract in advance with a predetermined time for it to be exercised, and a strike price that is not yet set. This means that, at a certain point in the future, the option will be exercised, or fulfilled at the price that is usually set at the time the option becomes active. If this price is below the current market value for the stock upon which the option is based, the investor makes a profit; but, if the strike price is higher than the market price at the time of sale, then the investor loses up to the full premium value that he or she paid for the option. An options contract can have several different types of time and price restrictions for trading, such as Barrier, Bermudan, or European options, but the forward start option is considered to be a type of Vanilla option, meaning that it has typical trading parameters.
An interested investor can purchase a forward start option without a predetermined price under one of three main approaches towards making a profit. These option types are known as call, put, or straddle investments. A call option means that the investor has a right to buy the option when it becomes active, and a put option means that the investor has the right to sell it when it becomes active. A straddle option is a hybrid of the two that gives the investor the right to both buy and sell the forward start option, though the strike price and expiration dates do not change.
Another form of investment in these instruments is often referred to as a ratchet, reset, or cliquet option, and is literally a connected series of forward start options that progress in time like links in a chain. The first forward start option in a ratchet is immediately active when purchased, and, when it expires, the second one in the chain becomes active. The idea behind these investments is that an incremental profit can be made if the options are following market trends.
The key feature of a forward start option that makes it worthwhile is that it has no set exercise price when it is purchased. This price is set at some point in the future between the time when the option becomes active on the market and when it expires. This makes such financial instruments a way to speculate on the movement of a market over that of the actual price of the commodity or stock upon which the option is based. A trader purchasing a forward start option is said to be literally trading on the “volatility of volatility” in the market itself.
The premium cost for a forward start option is paid immediately when it is purchased even though the option is usually not active immediately. This premium cost is often tied to the anticipated strike price itself, and is usually based on increments of $2.50 and $5.00 US Dollars (USD) as of 2011. The underlier and time of expiration for the forward start option are the other two elements that are also determined in advance. The underlier is the actual physical entity, whether a stock, bond, or commodity, upon which the option is based.
One of the uses for the forward start option format in investing is that of employee stock options (ESO) plans. These give employees of companies a chance to capitalize on volatility in the market as it progresses. Determining pricing for such options utilizes complicated mathematical formula, however, and is often based on the financial economist Mark Rubinstein's equations for the process created in 1979 in the US. The Black-Sholes mathematical model is also used, which is founded upon partial differential equations created in the early 1970s to track prices for options in financial markets.