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.
- A compound option is an option to receive another option as the underlying.
- The underlying is the second option, while the initial option is called the overlying.
- Compound options can involve two strike prices and two expirations dates. Also, if the compound option is exercised, two premiums.
Understanding the Compound Option
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.
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, 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.
Real World Example of Using a Compound Option
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 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 any more. The advantage is a lower initial outlay and reduced risk.