Compound Option
A compound option is an exotic derivative that gives the holder the right, but not the obligation, to buy or sell another option on a specified date at a predetermined premium, creating options on options that offer leveraged exposure to volatility changes and reduced upfront cost.
Compound options come in four varieties based on the combination of outer and inner option types: a call on a call, a call on a put, a put on a call, and a put on a put. In each case, there are two strike prices and two expiration dates. The first expiration is when the outer option matures and the holder decides whether to exercise into the inner option. The second expiration is when the inner option itself expires. Two premiums are paid: a small upfront premium for the outer option and the inner option premium paid only if the outer option is exercised.
The compound structure provides significant leverage relative to buying the inner option directly. Because the outer option premium is a fraction of the inner option premium, a trader who is correct about subsequent volatility movements pays far less upfront than a direct option buyer, magnifying the return on premium invested. However, this leverage is double-edged: if the outer option expires worthless, the entire premium is lost even though the inner option might have been profitable over its full life.
Compound options are most natural in situations where there is uncertainty about whether an underlying risk will materialize at all. A company negotiating a potential acquisition that may or may not proceed might use a compound option: if the deal is confirmed, they exercise into the inner option to hedge the currency or equity exposure; if the deal falls apart, the outer option expires worthless at limited cost. This staged decision structure mirrors real options logic used in capital budgeting.
In U.S. fixed income markets, compound options are implicit in the structure of callable bonds and mortgage-backed securities with prepayment options. The borrower's right to refinance a mortgage is an option to call the loan, and options written on these mortgage securities are effectively compound in nature. Quantitative analysts at fixed income desks at major broker-dealers use compound option models to value these embedded optionalities.
For listed equity options in the United States, compound option strategies can be synthetically constructed through sequential vanilla options, but the explicit compound option is an OTC product. Clearing, if any, would occur through bilateral collateral arrangements under ISDA master agreements governed by Dodd-Frank swap regulations where applicable.