Did you know you could buy an option on an option contract? While it sounds like you could be subjecting yourself to some pretty crazy leverage, the intended use is actually to reserve the right to purchase an option at a later date, rather than to apply hideous amounts of leverage. Further, compound options are, as far as I know, strictly an OTC (over the counter) security (I have never come across a compound option on an exchange, but I have never really looked, to be fair).
Let’s say someone want to purchase shares of ABC in 1 year from now (because they do not have the money to make the purchase right now, but expect a large sale to complete in 1 year, thus providing them with the cash to actually buy the shares). If they wanted to protect themselves from a rise in the price of ABC before they can buy it, they could purchase an option on ABC – for example a 1 year call option with a strike price of $50/share (perhaps ABC is trading today for $40). This option might be $2/share. Let’s further assume the company wants to buy 1 million shares.
But what if they don’t have enough money right now to even purchase the option? Afterall, while purchasing 1 million shares of ABC at $50/share would cost $50 million, just purchasing the option to buy it at $50 for the next 1 year would cost $2 million. In this case, they could buy an option on the option to limit the maximum purchase price they will pay.
This ‘compound option’ could need to be a 6 month call option with a strike price of $2.00 on the 1 year ABC $50 call option. (I know, it’s very confusing if you are not already familiar with options.) The compound option cost varies a lot depending on the volatility of ABC (more volatile = more expensive) If ABC was not very volatile at all the compound option might cost $0.08/share. The total cash outlay would be only $80,000 to basically secure the ability to purchase 1 million shares of ABC for no more $50/share for the next year (actually $52,080,000 after factoring costs of the options contracts).
NOTE: As Michael James points out, if the volatility of ABC was higher (20% versus 10%) the price of this compound option might be dramatically higher at about $1.10/share! See the comments section below for more information.
Now, if you recall, OTC options are not normally very liquid as the counterparties are dealing directly with eachother in a tailored agreement. So even if ABC started to trade at $60, meaning the compound options you bought for $80,000 are now worth over $10 million, you might be hard pressed to find a buyer for a compound option. You would more than likely have to exercise your compound option to purchase the regular option and then exercise THAT option to purchase ABC for $50 million and then sell it in the market for $60 million.
Incidentally, your net gain would be calculated as $60 million less the purchase price of $50 million, less the regular option purchase price of $2 million, less the $80,000 to purchase the compound option. This is a total gain of $7.92 million.
If ABC was trading below $50/share, you would just let the compound option expire worthless, you would not have spent the $2 million on the regular option, and you could just buy ABC on the open market.
Thanks to Michael James on Money for his help on this post.