What is a Compound Option?
A compound option is the opportunity to buy or sell an option.
How Does a Compound Option Work?
Let’s assume John Doe buys a call on an option to purchase 100 shares 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 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 shares of Company XYZ at $25 per share). This second premium, called the back fee, is $3,900.
Why Does a Compound Option Matter?
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.
Back fees are very much like fees paid to extend the life of an option. Though they represent an added expense, the broader picture is that the compound options they associate with offer 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.