These are also known as compound options, an aptly named shape that describes exactly what they are. They are also called Split fee options because they may involve two strikes, two rewards, and two expiration dates.
This form of option allows a trader to have a second option as an underlying asset, so this second of the two options usually expires later. The first option is called lie above Position.
The holder of an option on one option, if the excess is exercised, receives the second option (the underlying asset) and is then required to pay a premium based on the strike (compared to the current value of the underlying 100 shares of the second option) for example in stock). This payment is known as a refund. The advantage of the option on option is that the holder has the potential to exercise and purchase the second option, but without the potentially high costs of having the final underlying move many points against the position. In this regard, a price is frozen. This means that the initial cost of the position is lower than a full purchase of the underlying option. However, when the overlay is exercised, it is more expensive.
For those in such a position, the higher price to exercise is well worth the cost. Exercise only takes place if the price of the underlying has moved favorably (e.g. share price).
These options are not often used for stock-based options and are more likely to be found in speculative markets for currency rates, interest rate options, and other securities in the mortgage markets. In these markets, extending the life of an option can be beneficial when prices are moving slowly, but are expected to move with greater volatility soon, possibly due to seasonal influences or expected market developments.
The strategy of those trading options on options combines a relatively inexpensive initial option (overlaid) and extends its duration with the second option (underlying). Since the exercise only takes place if the overall position is valued favorably, the option on option is an economical alternative to buying a longer-term option. This becomes something of an insurance position as it will speculatively lower the initial cost, provided prices move cheap and result in an exercise (or prices are not moving cheap and the position is in the process of expiring).
An extension of the concept can include a synthetic option on an option. For example, a speculator buys a CoC and sells a PoC at the same time. If so, they are likely to expire on the same day and with the same strike. This secures the concept, but it also means that more movement is required to become profitable (as is always the case with a synthetic position). When considering the potential and risk of this approach, it should be clear that the complexity may not justify such a move. A simpler synthesis can offer the same benefits without as much risk, since the ideal synthesis is at or near a net premium of zero.
The complexity and risk are even more complicated when it comes to an option on an option sold rather than bought. This provides the trader with preferential cash flow but higher exercise risk, not to mention double the amount of collateral required. The short option to option could be covered, but is there real coverage of 100 shares per single option or 100 shares for each side? In this case, the underlying asset is not activated by the seller, but by the holder. For most traders, the risk of a short option-on option is too great and uncertain. Hedging advantages through plastics (or even straddles and spreads) could make the option on option interesting compared to trading the same positions in vanilla form.
The option on option is not suitable for everyone. In considering the many complex and exotic variations on the basic idea of the option, the appeal often lies in the complexity itself. Too many traders have been drawn to complex positions such as options on options because they are exotic and involve higher odds (as well as higher risks). However, the potential should be seen realistically.
Just as a complex strategy like a box spread or a butterfly is appealing to begin with, it has limitations. The profit potential is there, but it is usually limited. The same applies to many uses of the option on an option position. Premium costs and fees can undermine some (or all) of the initial profit, which can be minimal at best.
Traders attracted to exotic forms of options trading should take a step back before entering a trade. What is the real potential and risk? Given the complexity and need to constantly monitor and manage positions, does the complexity justify the potential profit? Would a trader enter a short-term long straddle without first considering the breakeven points above and below the strike? You would not. The same argument can be applied to the option on option and other exotic strategies. Traders might conclude that the attractiveness of complexity is not justified by limited profit with a higher level of risk than risk tolerance.
In other words, after considering the option to trade options, one possible conclusion is that it makes more sense to buy (or sell) individual calls or puts with a clear understanding of the risks that these more fundamental strategies pose.
Michael C. Thomsett is a widely published author with over 80 business and investment books, including the best-selling Get started with options coming in its 10th edition later this year. He also wrote the recently published The math of options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Publishing as well as Seeking Alpha, LinkedIn, Twitter and Facebook.