What it is:
How it works/Example:
Many investors know that they don’t always have to make outright purchases or sales of securities; they can also use puts and calls. But few investors know about compound options, which can be very useful but carry back fees.
For example, let’s assume that John Doe buys a call on an option to purchase 100 of Company XYZ at $25 per share by March 31. He pays $1,000 to the seller of that call. This arrangement is called a compound option—that is, it is an option to purchase an option.
Now let’s say that John Doe wants to exercise the call on the option. Now he must pay the premium on the second option (the option to buy 100 of Company XYZ at $25 per share). This second premium, called the back fee, is $2,500.
Why it matters:
Back fees are very much like fees paid to extend the life of an compound options they associate with a way for investors to “ride” a stock without investing as much capital as would be required for buying or selling the stock outright. This does not come without risk, however.