Call on a Put

What Is a Call on a Put?

A call on a put refers to a trading setup where there is a call option on an underlying put option, and it is one of the four types of compound options. If the option owner exercises the call option, they receive a put option, which is an option that gives the owner the right but not the obligation to sell a specific asset at a set price within a defined time period.

The value of a call on a put changes in inverse proportion to the stock price. This means the value decreases as the stock price increases and increases as the stock price decreases. A call on a put is also known as a split-fee option.

Key Takeaways

  • A call on a put is a kind of trading setup where there is a call option on an underlying put option.
  • A call on a put is one of our types of compound options.
  • Another trading term is a seagull option, which is made up of two calls and a put, or two puts and a call.
  • A call on a put has two expiration dates and two strike prices, plus two option premiums.
  • Companies might use a call on a put during a bidding process for a potential work contract.

Understanding a Call on a Put

A call on a put will have two strike prices and two expiration dates, one for the call option and the other for the underlying put option. Also, there are two option premiums involved. The initial premium is paid up front for the call option, and the additional premium is only paid if the call option is exercised and the option owner receives the put option. The premium, in this case, would generally be higher than if the option owner had only purchased the underlying put option, to begin with.

Two calls and a put or two puts and a call are referred to as a seagull option.

Example of a Call on a Put

Consider a U.S. company that is bidding on a contract for a European project. If the company's bid is successful, it will receive 10 million euros upon project completion in one year. The company is concerned about the exchange risk posed by the weaker euro if it wins the project. Buying a put option on 10 million euros expiring in one year would involve a significant expense for a risk that is as yet uncertain (since the company is not sure that it would be awarded the bid).

Therefore, one hedging strategy the company could use would be to buy, for example, a two-month call on a one-year put on the euro (contract amount of 10 million euros). The premium, in this case, would be significantly lower than it would be if it had instead purchased the one-year put option on the 10 million euros outright.

On the two-month expiry date of the call option, the company has two alternatives to consider. If it has won the project contract, is in a winning position, and still desires to hedge its currency risk, it can exercise the call option and obtain the put option on 10 million euros. Note that the put option will now have 10 months (12 - 2 months) left to expiry. On the other hand, if the company does not win the contract or no longer wishes to hedge currency risk, it can let the call option expire unexercised and walk away, paying less in premiums overall.

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