What is a Back Fee
A back fee is a payment made to the writer of a compound option if the second 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. Then, if the first option is exercised, the premium on the second option will be paid. This is the back fee.
A back fee may also refer to extending an exotic option. If an exotic option is extended past the original expiry date, this advantage will often require the payment of another premium to cover the new term of the option.
Breaking Down the Back Fee
Back fees are important to consider when dealing with compound, or other types, of exotic options. Exotic options, including compound options, trade over the counter (OTC), and are therefore subject to counterparty risk.
Back Fees and Compound Options
A compound option is when a trader buys an option to buy another option. For example, they buy a call option on a call option. The benefit of such an option is that it allows the trader to gain possible exposure to the underlying asset at a cheaper price than buying a vanilla call option outright. A trader must consider, though, that this transaction could require two premiums to be paid.
The first premium buys the call on the call. If it is worthwhile to do so, the trader will exercise 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. Additionally, if the trader decides to exercise this second option to buy the underlying asset, this would incur additional broker commissions and fees.
Back Fee to Extend Options
Certain exotic options may have a feature that allows the holder to extend the expiry date of the option. This gives the holder flexibility to prolong their exposure to the underlying without buying a new option. That said, if the option is extended 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.