What is a Put On A Call
One of four compound options types, a put on a call (PoC) is a put option for which the underlying is a call option. Therefore, there are two strike prices and two exercise dates.
The following compound options are available:
- Call on a put - CoP (CaPut)
- Call on a call - CoC (CaCall)
- Put on a put - PoP
- Put on a call - PoC
Compound options may be known as split-fee options.
BREAKING DOWN Put On A Call
When the holder exercises a put on a call, called the overlying option, he or she must then deliver the underlying call option to the seller and collect a premium based on the strike price of the overlying put option. This premium is called the back fee.
Alternatively, when the holder exercises a compound call option, he or she must pay the seller of the underlying option a premium based on the strike price of the overlying call 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.
In the mortgage market, PoC options are useful to offset the risk of interest rate changes between the time a mortgage commitment is made and the scheduled delivery date.
Traders may use compound options to extend the life of a bearish options position since it is possible to buy a put with a shorter time to expiration for another put with a longer expiration. In other words, they can participate in the losses of the underlying without putting up the full amount to buy it at expiration. 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 an insurance policy.
The same is also true for institutions providing the financing as they seek to hedge their exposure should if they commit to providing the money needed by businesses for their projects and those businesses do not win their deals.