An option whose underlying is a forward contract. This option gives the holder the right to enter into a forward contract whereby he can buy or sell a specific underlying asset at a certain future time for a certain price determined in the forward contract. In a forward option, the contract specifies a period of time, rather than a certain date, during which the holder will exercise his right to trade the underlying. The forward option is, in essence, an agreement to trade in the future for a fixed price set today. There are several types of financial forward contracts that are used as underlying. Financial institutions quote forward exchange rates for commercial customers. Forward contracts on Treasury securities, known as when issued (WI) contracts trade in the week preceding a Treasury auction. Furthermore, the so-called “to be allocated” (TBA) mortgage-backed securities can be sold forward. Options on such contracts or instruments trade over the counter daily among wholesale dealers in the underlying cash securities.

An example is a forward call option which gives the holder, if exercised, a long forward contract associated with a specific exercise price. The value of the exercised call is equal to that of the delivered forward contract.