Compound Options

Compounds options in a basic sense are an option on an option. Each compound option has two strike prices and two expiration dates. There are also two option premiums, one paid upfront and the other is paid for the underlying option if the compound option is exercised. The premium for the compound option is usually low but the combined total of both options are greater than the premium of an option that is not a compound option.

On the first expiration date, the holder can buy a new call at the first strike price. The new call will then have a second expiration date and a second strike price.

Compound options can be made into extendable options. Extendable options have two forms:

Holder Extendable: The holder can pay an additional premium to extend the options past it original expiration date.

Write Extendable: If a certain condition is met, i.e. the option being out of the money, the option is automatically extended. No additional premium is paid.

There are four basic types of compound options:

• Call on a Call
• Put on a Put
• Call on a Put
• Put on a Call

Compound options can be extremely sensitive to volatility. Several models include the Black-Scholes assumption of constant volatility and can under estimate the options.

The 4 formulas for pricing the options can be found on the following link:


Compound options are very common in fixed income or currency markets where insecurity exists in the options risk protection. Another area this is used is to hedge business projects that may or may not fail.


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