Compound Options (Words<500)
A compound option is an option on another option. A split-free or compound option is an option for which an underlying asset is an option. Compound options have two strike prices and two expiry dates and also two premiums if the option is exercised. Compound Option provides the owner with the right to buy or sell another option. The first option is called overlying and the second option is called underlying. Compound options can be of any combination of Calls & Puts.
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Types of Compound Options:
There are 4 types of compound options:
- Call on Call (CoC)
- Call on Put (CoP)
- Put on Put (PoP)
- Put on Call (PoC)
How does it work?
When the holder exercises a compound call option which is the overlying option, they must then pay the seller of the underlying option a premium based on the strike price of the compound option called the back fee. The compound option gives the investor some exposure to the put option now, but without the cost of paying for a long-term put option right now. Having said that, if they exercise the initial call option and receive the put, the premiums paid will likely be more expensive than having just bought a put in the first place.
Example:
Let’s assume Jaden buys a call on an option to purchase 50 shares of Nestle at $20 per share by March 31. He pays $1,000 for the call to the seller. This arrangement is called a compound option.
Jaden wants to exercise the call on the option. Now he must pay the premium on the second option (the option to buy 50 shares of Nestle at $20 per share). This second premium known as the back fee is $1000.
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How can traders use the Compound option?
Traders use compound options to extend the life of an option’s position since it enables them to buy a call with a shorter time to expiration for another call with a longer expiration, for example. In other words, they participate in the gains of the underlying without putting up the full amount to buy it at the onset. The caveat is that two premiums are paid and at a higher cost if the second option is exercised.
Bottom Line:
Companies often use compound options when filing a tender for the contract as the option hedges against the risk of winning contracts. The decision to exercise the compound option depends on the holder at the time of expiry.
Author: Urvi Surti
About the Author:
Urvi is a commerce graduate and has a keen interest in Finance. She has completed her Chartered Wealth Management (CWM) from the American Academy of Financial Management and is currently pursuing a career in Financial Risk Management (FRM).
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