What is a Compound Option
A compound option is an option for which the underlying asset is another option. Therefore, there are two strike prices and two exercise dates. They are available for any combination of calls and puts. For example, a put where the underlying is a call option or a call where the underlying is a put option.
Each pair has an abbreviation:
Compound options may be known as split-fee options.
BREAKING DOWN Compound Option
When the holder exercises a compound call option, called the overlying option, he or she 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.
Alternatively, when the holder exercises a compound put option, he or she must deliver the underlying option to the seller of the compound option.
It is more common to see compound options in currency or fixed-income markets, where an 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 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. 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.
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 a sort of insurance policy.
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 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. And if they do not win the contract, they can let the option expire. The advantage is a lower initial outlay and reduced risk.