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Compound Options

Written By

James Barra

Written By

James Barra

James is an investment writer with a background in financial services. As a former management consultant, he has worked on major operational transformation programmes at prominent European banks. James authors, edits and fact-checks content for a series of investing websites.

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Edited By

Jemma Grist

Edited By

Jemma Grist

Jemma is a writer, editor and fact-checker focused on retail trading and investing. Jemma brings a unique perspective to the forex, stock, and cryptocurrency markets and works across several investment websites as a researcher and broker analyst.

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Fact Checked By

William Berg

Fact Checked By

William Berg

William contributes to several investment websites, leveraging his experience as a consultant for IPOs in the Nordic market and background providing localization for forex trading software. William has worked as a writer and fact-checker for a long row of financial publications.

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Updated

Jul 1, 2024

A compound option is best thought of as an option where the underlying security is also an option. There are two strike prices and two exercise dates, providing investors additional flexibility and potentially lower initial costs.

Below we list the top-rated brokers that offer retail options trading in 2024.

What Are Compound Options?

Compound options are effectively an option on an option. Traders purchase an option for the right to buy a contract for an underlying asset on the stock, forex or crypto market, for example. This means there are two separate contracts, where the underlying security for the first is the second contract, while the second pertains to the real asset. In essence, a compound option features two contracts which expire at separate times with different strike prices and valuations.

This type of financial derivative is particularly popular in forex and fixed-income markets, owing to limitations in an option’s risk management capabilities.

How Trading Compound Options Works

There are two contracts, the overlying option and the underlying option. A call option gives the holder the right to buy an asset and a put option gives the holder the right to sell an asset.

If a trader invests in a compound call option (CoC or CoP), they must pay the seller of the underlying option a premium, known as the back fee, based on the strike price of the option. This gives the trader exposure to the underlying option without the cost of a long-term contract. However, if they exercise the call it will work out more expensive than just having bought a standard option in the first place.

Types Of Compound Options

Compound options trading falls into four key categories:

• Call on a Put (CoP): If the holder of the original call exercises it, they receive a put option. This is used to increase exposure to an underlying asset at a low price.
• Call on a Call (CoC): The trader purchases a call option with the right to purchase an underlying call option on an asset.
• Put on a Put (PoP): A put purchased on top of a put contract. This type of compound option performs well when the underlying asset, the second contract, is based upon gains value.
• Put on a Call (PoC): The trader decides whether to sell the underlying call option to the seller. They receive a premium based on the strike price of the original put contract.

Compound Options Characteristics

The key characteristic of compound options trading is a formula known as “compound option parity”. It can be derived using the assumption that two portfolios with the same payoff should have the same price. The formula is:

P(CoC) – P(PoC) = P(Call) – PV(Strike Price)

P() indicates the price of the option inside the parentheses and PV() indicates the present value. The formula can also be derived for a call on put option:

P(CoP) – P(PoP) = P(Put) – PV(Strike Price)

Example

The compound options trading method is best explained through a simple example…

An investor wants to sell 50 Meta Platforms Inc (formerly Facebook Inc) shares at $150. Once they sign into an account with their login credentials, they see the live price of Meta is $160.02. They plan to purchase a CoP compound option for $1 per share, working out as a back fee of $50. The underlying option to sell stock has a strike price of $50.

When the trader purchases the CoP option, they pay the $50 back fee. They do not have to pay the fee for the second option right away, it is only required if they exercise the right to purchase in the first contract. If they choose to do so, they will receive the second option.

History Of Compound Options

Interest in trading compound options dates back to 1973 when economists Black and Scholes released ‘The Pricing of Corporate Liabilities’ paper. A vanilla option is a simple call or put option with no special features or observation dates and a European style option requires the option to be ‘in the money’ on the expiration date in order for it to be exercised.

Black and Scholes derived formulas for a vanilla European call and put options while considering a way to calculate the equity of a company that has coupon bonds outstanding. They argued equity can be viewed as a “compound option” because it “is an option on an option on the firm,” though there was limited advancement of this for the next five years.

In 1979, a further perspective was offered, in another paper, titled “The Valuation of Compound Options”. The author, Geske, developed a closed-form solution for the price of a vanilla European call on a European call. This highlighted a range of issues related to the valuation of compound options, and since then many have tried to answer the question. Following years of papers by well-respected fellows in the Economics industry, various issues have been resolved.

Pros Of Compound Options

• Companies can use them as a form of insurance if they need to finance supplies for potential building work, for example
• Provides exposure to an asset without commitment
• Derivatives available with leverage/margin
• Cheaper initially

Cons Of Compound Options

• Higher premiums than standard contracts, if exercised
• Not offered by many brokers

Strategy

A popular strategy for trading compound options is known as the ‘Collar Strategy’. It can also be known as a ‘hedge wrapped’ or ‘risk-reversal’, and it is used to protect against significant losses. However, it will also limit large gains at the same time.

The strategy was originally developed for standard options contracts. It consists of simultaneously buying a put and selling a call, against a set number of shares of long stock. The put is there to protect the trader in case the price of the stock drops. The call is where the income is generated, it allows the trader to profit up to the strike price of the call (but not above it).

The Collar strategy pairs with compound options trading. If instead, the investor buys a compound option for the put and call positions, they will pay a small fee on each initially, and then only a full premium on the one they exercise. This means the overall premiums paid should be lower than if they bought a standard contract for each.

Further information and videos examining compound options strategies can be found on Discord, Reddit and YouTube.

Why Should You Trade Compound Options?

Compound options trading allows investors to trade with substantial leverage, potentially increasing profits. While this can be risky, traders can choose not to exercise the first option. It may also be cheaper to start with a compound option, especially if an investor feels unsure about which way the market will turn. Another reason to trade compound options is that the investor can benefit from future volatility. When the compound option is purchased, the price of the underlying asset is locked in, so if there are large swings in value the trader could do well.

How To Start Trading Compound Options

Follow this step-by-step guide to start trading compound options today:

1. Choose a broker: First, open an account with a broker that offers compound options trading. When choosing a provider, there are several things to consider. Check that they offer 24/7 customer service with a contact phone number. Also see if they have a mobile app or if the platform is available on Mac. Also, consider the various daily fees quoted by the broker and the typical premium for a compound option.
2. Research the market: Once you are signed up to a broker, explore the various markets they offer. Try to pick one that you feel knowledgeable about, such as stocks, forex or commodities.
3. Choose the contract type: There are four standard types of compound options contracts to choose between, as discussed earlier. Choose the type that suits your goals best. For instance, if you are looking to employ leverage, a Put on a Put (PoP) could be the best option.
4. Open, monitor and exercise: Purchase the compound option contract and track its performance. If the market moves in the right direction, you can exercise your right to the underlying options contract. Monitor the asset using an indicator/chart and wait for the right moment to exercise the option.

Final Word On Trading Compound Options

Compound options trading is an exotic form of standard options. They are effectively an option on an option, allowing the trader to lock in a price without committing to the full premium. The initial fee is lower, however, if a trader exercises the option the premium will be higher overall. Use our step-by-step guide to get started today.

FAQs

Where Can I Start Trading Compound Options?

See our list of the best brokers for trading compound options in the stock market or other assets. Note, it is not possible to trade this type of option on Robinhood, NinjaTrader 8, TradeStation, Trading 212, Zenith or Webull.

Can You Trade Compound Options On TradeZero?

TradeZero does not offer compound options. However, investors can still trade standard options contracts.

Are Compound Options Exotic?

Compound options are a type of exotic option. They are effectively an option on an option providing investors with additional flexibility.

Do All Brokers Offer Compound Options Trading?

No, not all brokers offer compound options trading. Check out our list to see the best supporting brokers in 2024.