What is a Compound Option?

Malcolm Tatum

A compound option is an investment approach in which the underlying option is actually a second option. This creates a situation in which the overall strategy involves two strike prices as well as two different strike dates. There are several different ways to structure a compound option, using a set of puts and calls in various configurations. Deciding on the exact configuration to use will often depend on what type of outcome the investor can reasonably anticipate, given the prevailing market conditions and the projections of how the market is likely to move in the future.

Man climbing a rope
Man climbing a rope

The idea behind the use of a compound option is to minimize the degree of risk that is associated with the investment. At the same time, a strategy of this type also offers the benefit of being cheaper than a single option as far as the actual creation of the dual method. The investor also enjoys more leverage and stands to earn a better return, depending on the performance of the two options involved.

In arranging the compound option, the investor may choose to use what is sometimes known as a straight compound option. This is simply a call that is placed on another call, or a put that is placed on another put. It is also possible to use a call on a put approach, sometimes known as a caput option, or reverse the sequence with a put on a call strategy. The choice of which combination to use depends on the nature of the options involved, their projected performance, and the general nature of the market that the options are associated with.

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The use of a compound option is especially helpful when considering investments connected with the currency market. This same approach is also sometimes helpful when considering investments that have to do with the fixed-income market. A compound option approach can also be useful when creating a hedging strategy with different types of business projects.

It is important to note that while an compound option is usually a little less expensive on the front end, there is a strong likelihood that it will be a little more expensive if both options are ultimately exercised. Assuming that the strategy is successful and the investor earns an equitable return, this difference in cost will easily be absorbed, allowing the investor to still come out ahead of using some other method. As with any type of investment approach, it is important to analyze the particulars related to the options, predict their movements as accurately as possible, then decide on what strategy will result in providing the most financially rewarding outcome.

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