What Is a Compound Option?
A compound option is an option for which its underlying security is another option. Therefore, there are two strike prices and two exercise dates.
Each pair has an abbreviation:
Compound options may be known as split-fee options.
- A compound option is an option to receive another option as the underlying security.
- The underlying is called the second option, while the initial option is called the overlying.
- Compound options can involve two strike prices and two expirations dates.
- If the compound option is exercised, two premiums are involved.
Understanding Compound Options
When the holder exercises a compound call option, called the overlying option, they must then pay the seller of the underlying option a premium based on the strike price of the compound option. This premium is called the back fee.
For example, assume an investor wants to buy a put to sell 100 shares of stock at $50. The stock is currently trading at $55. The investor could buy a CaPut, which allows them to buy a call now, for say $1 per share ($100), which will allow them to buy a put with a $50 strike in the future. They pay the $1 per share now, but only need to pay the fee for the second option if they exercise the first resulting in them receiving the second option.
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. That said, 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.
In the case of a PoP or PoC, the compound option provide the right to sell a put or call as the underlying.
Compound Option Variations
- 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. 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 it can be used in real estate development to secure property rights without being obliged to commit.
- 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. Companies might use a call on a put during a bidding process for a potential work contract.
- 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. A put on a call option can be used by an investor to extend their hedge on an underlying asset at a low cost, and it can be used in real estate development to get out of property rights without being obligated to the deal.
- Put on a put: A put is purchased on a put contract and gains in value when the put contract falls in value, i.e., when the underlying security that the second option is based upon rises. A put on a put option is used when a bullish trader wants to employ leverage.
Compound options are more common in European than American derivatives markets.
It is more common to see compound options in currency or fixed-income markets, where uncertainty exists regarding the option's risk protection capabilities. The advantages of compound options are that they allow for large leverage and they are cheaper, initially, than straight options. However, if both options are exercised, the total premium will be more than the premium on a single option.
Traders may use compound options to extend the life of an options position since it is possible to buy a call with a shorter time to expiration for another call with a longer expiration, for example. In other words, they can participate in the gains of the underlying without putting up the full amount to buy it at the onset. The caveat is that there are two premiums paid and a higher cost if the second option is exercised.
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 a sort of insurance policy.
Example of Using a Compound Option
For example, a company bids to complete a large project. If they win the bid, they will need financing for $200 million for 2 years. However, the formula they use in the calculation takes current interest rates into consideration. Therefore, the company will have exposure to possible higher interest rates between the contract bidding and possible winning. They could buy a two-year interest rate cap beginning the date of the contract award but this could be very expensive if they do not win the contract.
Instead, the company could buy a call option on a two-year interest cap. If they win the contract, they then exercise the option for the interest rate cap at the predetermined premium because they will need it for the project. And if they do not win the contract, they can let the option expire because they don't need the underlying anymore. The advantage is a lower initial outlay and reduced risk.