What Is a 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; it is an option on an option. The front fee gives the investor the right, but not the obligation, to exercise the initial option to receive the underlying option. If exercised, another fee known as the "back fee" is payable for the underlying option's premium. Note that the second option may be exercised to make a final transaction in the underlying asset itself.
For instance, you could buy a compound option to buy a call on euros. If you exercise the compound option, this then gives you the right to buy euros at a pre-set exchange rate at or before a certain point of time has passed. If you exercise that second option, you obtain the euros.
- The front fee refers to the premium outlay for the initial purchase of a compound option.
- A compound option is effectively an option to buy or sell another option, such as a call on a put or a put on a put.
- The premium on the underlying option's contract, or back fee, would only be paid if the compound option is exercised.
- The option-on-an-option provides a lower upfront cost and more flexibility than purchasing protection directly (which may not be needed).
Understanding the 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. They purchase an option to buy a foreign currency option, and then they only need to use the initial option (to receive the underlying one) if needed and worthwhile to do so.
Compound options come in four configurations:
- Call on a put, called a CoP (CaPut), which is the right to buy a particular put option.
- Call on a call, called a CoC (CaCall), which is the right to buy a particular call option.
- Put on a put, called a PoP, which is the right to sell a particular put option.
- Put on a call, called a PoC, which is the right to sell a particular call option.
The option premium associated with the purchase of either of these four arrangements would be the front fee and is paid to the seller of the compound option. For example, if and when a call on a put 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 in a Compound Option Stock Trade
An example of a front fee would be to pay $6 for two call-on-a-call option contracts in Apple Inc. (AAPL). The contracts give the right to purchase AAPL 250 strike calls with an expiry in three months. The stock is currently trading at $225. For the two contracts, the cost is $1,200 ($6 x 200 shares, since each contract is for 100 shares).
This is a cheaper strategy when the chance of the stock rising above $250 within the next three months is low. The premium that would have to be paid for the three-month 250 calls outright would be $27 per contract, or $5,400 ($27 x 200 shares)
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.