Cliquet Option
A cliquet option, also called a ratchet option, is an exotic derivative consisting of a series of forward-starting options that automatically reset their strike price to the prevailing underlying price at each predetermined reset date, locking in interim gains and resetting exposure at current market levels.
The cliquet structure solves a problem with standard long-dated options: an option purchased today with a fixed strike set two or three years out can quickly move deep in-the-money or far out-of-the-money as markets evolve, losing its utility as a hedge or directional instrument. A cliquet avoids this by subdividing the contract life into multiple sub-periods, each with its own forward-starting option that sets its strike at the beginning of that period at the then-current market price.
At each reset date, any gains from the previous period are locked in and cannot be taken away by subsequent adverse movements. The cumulative payoff is often the sum of the individual sub-period returns, each floored at zero so that losing periods do not claw back gains. This ratcheting feature makes cliquets attractive for capital-protected structured products marketed to retail and institutional investors who want equity market participation with downside protection built into the payoff structure itself.
Pricing cliquet options is considerably more complex than pricing vanilla options. Because the strikes reset at future market levels that are themselves uncertain, the pricing model must account for the forward volatility — the expected volatility over future periods, not just current implied volatility. The volatility surface and its term structure are critical inputs; specifically, the correlation between volatility at different future dates (the vol-of-vol and forward vol dynamics) heavily influences fair value. Models that only use flat volatility surfaces misvalue cliquet products significantly.
U.S. broker-dealers structure cliquet options into equity-linked notes and principal-protected products that are sold to institutional and high-net-worth investors. The underlying may be the S&P 500, a basket of large-cap equities, or a commodity index. The OCC processes the equity options component of any exchange-listed hedges dealers use to manage their cliquet book, though the cliquet itself is an OTC product.
For investors in structured products, understanding the cliquet mechanism matters because the premium for the ratchet feature is substantial. The forward vol uncertainty embedded in cliquets makes them expensive relative to simple long-dated vanilla options on the same underlying, and the realized payoff depends heavily on the timing and magnitude of market returns across each sub-period.