DEFINITION of 'Front Fee'

The front fee is the option premium paid by an investor upon the initial purchase of a compound option. A compound option is one where the underlying asset is also an option (i.e. it is an option on an option). The front fee gives the investor the right - but not the obligation - to exercise the  option on the option. If exercised, another fee known as the "back fee" is payable for the underlying option. Finally, the second option may be exercised to make a transaction in the underlying asset.

BREAKING DOWN 'Front Fee'

Compound options are used in situations where uncertainty exists regarding the requirement for risk mitigation. For example, a company may submit a bid for an overseas project. If successful, the project would generate significant revenue in a foreign currency, which may need to be hedged against exchange rate risk. A compound option would be useful in this case, because the front fee payable would be lower than the premium payable on a foreign currency option contract (which is a contingent liability in any case).

Compound options come in four configurations:

  • Call on a put - CoP (CaPut) - the right to buy a particular put option.
  • Call on a call - CoC (CaCall) - the right to buy a particular call option.
  • Put on a put - PoP - the right to sell a particular put option.
  • Put on a call- PoC - the right to sell a particular call option.

The option premium associated with the purchase of either of these 4 arrangements would be the front fee and is paid to the seller of the compound option. If and when a call on a put (for example) is exercised, the option holder will purchase a put and pay the premium for that option as the back fee.

Example of the Front Fee

An example of a front fee would be to pay $1,000 for a call on a call compound option, with the right to purchase the XYZ June 50 strike calls, when the stock is trading at $40. This is a cheaper strategy when the chances of the stock rising above $50 before June are low. The premium that would have to be paid for the June 50 calls outright would be, say, $4,500.

Typically, compounded options are not used in options on stocks or equity indexes. They are mostly used in currency or fixed income markets where firms have insecurity or uncertainty regarding the need for an option’s risk protection. Another common business application that compound options are used for is to hedge bids for business projects that may or may not be accepted.

RELATED TERMS
  1. Put On A Call

    One of four compound options types, a put on a call is a put ...
  2. Back Fee

    The back fee is the premium paid for the second option in a compound ...
  3. Vanilla Option

    A vanilla option gives the holder the right to buy or sell an ...
  4. Put Option

    A put options gives the owner the right to sell a specified amount ...
  5. Outright Option

    An outright option is an option that is bought or sold individually. ...
  6. Seller

    A seller is an entity who writes an option contract and collects ...
Related Articles
  1. Trading

    Beginners Guide To Options Strategies

    Find out four simple ways to profit from call and put options strategies.
  2. Investing

    Why Options Trading Is Not for the Faint of Heart

    Trading options is not easy and should only be done under the guidance of a professional.
  3. Trading

    Getting acquainted with options trading

    Learn about trading stock options, including some basic options trading terminology.
  4. Trading

    Call options: Right to buy versus obligation

    Learn what a call option is, how buyers and sellers are determined, and what the difference between a right and an obligation is for options investors.
  5. Trading

    Option trading strategies: A guide for beginners

    Options offer alternative strategies for investors to profit from trading underlying securities. Learn about the four basic option strategies for beginners.
  6. Trading

    The Basics Of Option Price

    Learn how options are priced, what causes changes in the price, and pitfalls to avoid when trading options.
  7. Investing

    What are Options Contracts?

    An explanation of options contracts, call options and put options.
  8. Trading

    Google Stock Too Expensive for You? Try Options

    Learn how to invest in Google (now Alphabet, Inc.) and other high-value stocks with less capital by using options.
  9. Trading

    A Quick Guide To Debt Options

    Options on debt instruments provide an effective way for investors to manage interest rate exposure and benefit from price volatility, learn more today.
RELATED FAQS
  1. What is index option trading and how does it work?

    Learn about stock index options, including differences between single stock options and index options, and understand different ... Read Answer >>
  2. How do I change my strike price once the trade has been placed already?

    Learn how the strike prices for call and put options work, and understand how different types of options can be exercised ... Read Answer >>
  3. How is a put option exercised?

    Learn the process, and what happens, when you exercise a put option. Also, read about alternatives to exercising an option. Read Answer >>
  4. When is a put option considered to be 'in the money?'

    Learn about put options, how these financial derivatives work, and when put options are considered to be in the money related ... Read Answer >>
  5. When does one sell a put option, and when does one sell a call option?

    An investor would sell a put option if her outlook on the underlying was bullish, and would sell a call option if her outlook ... Read Answer >>
Trading Center