What Is a Back Fee?
A back fee is a payment made to the writer of a compound option when and if the first option is exercised. Since a compound option is an option contract to buy another option, only the premium on the first option is paid upfront. If the first option is then exercised, the premium on the second option is paid, which is the back fee. In certain cases, a back fee may also refer to extending an exotic option.
- Back fees are payments made to the writer of a compound option when and if the first option is exercised.
- A compound option is an option contract to buy another option where the premium on the second option, known as the back fee, is due only when the first option is exercised.
- These fees are important to consider when dealing with more complicated investment types including compound options or other exotic options.
- Although they are additional expenses, back fees allow investors to take advantage of the movement of the underlying security.
- Back fees also relieve traders of the burden of putting up more capital to invest in the asset itself.
Understanding a Back Fee
An option is a derivative based on the value of an underlying security. This contract gives the buyer the opportunity to buy or sell the underlying asset without obligating them to do so. Options are either call options or put options. A compound option, as the name denotes, would be either a call or put, and is made up of more than one element. It's an option that has two strike prices and two exercise dates, or a contract to purchase another option.
A trader must consider, however, that this transaction may require two premiums to be paid. When the contract owner exercises the compound call option, the seller gets a premium on the underlying option.
Based on the compound option's strike price, this premium is called a back fee. Back fees are important to consider when dealing with compound options or other exotic options. Exotic options, including compound options, trade over-the-counter (OTC), and are thus subject to counterparty risk.
Premium Process on a Compound Option
Here's how these premiums work. The first premium buys the call on the call. If it is worthwhile to do so, the trader exercises the first call to get the second call. The exercising of the first option means the trader is now the holder of the second option—and the first option no longer exists—which requires a premium to be paid since the trader now owns a different option.
Although they generally add to the cost of an investment, back fees allow investors to take advantage of the movement of the underlying security, such as a stock, without the need to put up the capital required to buy the asset itself.
Options are not only traded speculatively to earn a profit but are also traded as a hedge. Using an option as a hedge can reduce the risks associated with investing in an asset without severely limiting the upside potential. Commodity companies often use options as a hedging tool, along with futures, to hedge their price risk.
Certain exotic options may have a feature that allows the holder to extend the expiry date of the option. They give the holder flexibility to prolong their exposure to the underlying without buying a new option. If the option is extended past the original expiry date, another premium will likely need to be paid to cover the new term of the option.
Since options have extrinsic value—as well as potentially intrinsic value—when the expiration date of an option is extended, the extrinsic value of that option will increase. The value of that increase will be paid to the option seller in the form of an additional premium.