A time-dependent option that locks in gains once predetermined price levels are reached by the underlying. The “ratchet” label refers to the set of predetermined price levels which are technically termed “rungs”. Those price levels are usually determined in specific laddering distances above (for a call) or below (for a put) the exercise price in percentage form (5% or 10%). For instance, the underlying asset price is $50 and the exercise price of a ratchet call is $50 and its rungs are $51, $52, $53, and $54.

The payoff at maturity is the difference between the furthest rung the price reaches during the option’s time to maturity and the exercise price. Otherwise the option expires worthless because it has not reached any of the rungs. Let’s suppose the underlying price hits $51. That automatically locks in a $1 profit no matter what downward path the underlying price follows. If that price dropped then to $40 and bounced back to $52, another $1 dollar gain is locked in. Now maturity date falls and the highest price reached by the underlying has been $53.5, consequently the option is said to have hit the $53 rung and a $3 gain is locked in. The option payoff at maturity is the difference between the highest rung reached and the exercise price ($53- $50= $3).

The ratchet option is also known as a moving strike option, a ladder option, a lock-in option, a cliquet option, or a reset option.