What Is a Call on a Call?
A call on a call (CoC, or CaCall) is a type of exotic option that gives the holder the right to buy a call option on the same underlying. Essentially, a call on a call option is an option to buy an option. It will have two strike prices and two expiration dates. One is for the compound call option, and the other is for the underlying vanilla option.
- A call on a call option is an exotic option that gives the holder the right to purchase a plain vanilla option before the contract expires.
- A call on a call is therefore a type of compound option on an option involving a call to buy a call.
- A call on a call option can be used by an investor to extend their exposure to an underlying asset at a low cost and can be used in real estate development to secure property rights without being obliged to commit.
How a Call on a Call Works
Call on a call options are a type of exotic option with customized terms that trade on alternative exchanges. With a call on a call option, the holder has a secondary call option which gives them the right but not the obligation to buy a plain vanilla call option with specified terms at a specified price.
A call on a call can be beneficial to an investor if it is offered at an optimal price. The holder of the secondary call has the right but not the obligation to buy a plain vanilla call. Generally, call on a call options are structured with American exercise. Thus, the investor has until the expiration date to exercise the secondary call. The secondary call and plain vanilla call can be exercised simultaneously or separately.
If the investor exercises the compound call simultaneously, then they believe the plain vanilla call is in the money and at its most profitable peak. When both compound options are exercised, the investor receives the underlying call option which is then immediately exercised for receipt of the underlying security. If the compound option holder chooses to only execute the first leg of the contract, then they will receive the plain vanilla call option at its specified expiration and exercise price for future enactment.
In some cases, a call on a call option can be used by an investor to extend their exposure to an underlying asset at a low cost. Many options allow a roll feature that provides for extended exposure, but a call on a call option may allow this at a lower cost. For example, if the compound call holder finds the price of the underlying call option to be beneficial to their investment plans, they may exercise the first leg of the option to obtain the plain vanilla option with a future expiration date.
Pricing a Call on a Call
Before expiration, the value of the plain vanilla option will depend on the value of the asset the underlying option represents. In the options market, investors may use several methodologies to calculate the value of their option. The Merton model is one method that has been introduced for compound options.
A compound call on a call option is a complex option that carries higher costs (premiums) than vanilla options. The investor will also be required to pay a transaction cost that factors in the execution of both options. The cost of the compound option is important to consider as it can decrease the profitability of the investment overall.
Other Compound Options
The other three types of compound options are:
- Call on a put: This is a call option on an underlying put option. The owner who exercises the call option receives a put option.
- Call on a call: In this option, the investor buys another call option with customized provisions. These provisions include the right to buy a plain vanilla call option on an underlying security.
- Put on a call: The investor must deliver the underlying call option to the seller and collect a premium based on the strike price of the overlying put option.
These options are also known as split-fee options.
Real World Application
While speculation in the financial markets will always be a major portion of compound option activity, business enterprises might find them useful when planning or bidding on a large project. In some cases, they must secure financing or supplies before actually starting or winning the project. If they do not build or win the project, they could be left with financing they do not need. In this case, compound options provide an insurance policy.
The same is also true for lenders, as they seek to hedge their exposure should they commit to providing the money needed by businesses for their projects, and those businesses do not win their deals.