SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

Options on Options


Traders have long known that options can be opened on many different securities. Among the most ingenious of these are options on options. There are four types of these: call on a call (CoC), a call on a put (CoP), a put on a call (PoC), and a put on a put (PoP).

These also are termed compound options, an aptly named form that describes exactly what they are. They also are called split-fee options because they involve potentially two strikes, two premiums, and two expiration dates.
 

This form of option allows a trader to receive a second option as the underlying, so that this second of the two usually expires later. The first option is called the overlying position.


The holder of an option on an option, upon exercise of the overlying, receives the second option (the underlying), and is then obligated to pay a premium based on the strike (compared to current value of the second options’ underlying, 100 shares of stock, for example). This payment is called the back fee. The advantage to the option on option is that it allows the holder potential of exercise and acquisition of the second option, but without the possible high cost if the ultimate underlying moves many points against the position. It freezes a price in that regard. This means the initial cost of the position will be lower than an outright purchase of the underlying option; but if the overlying is exercised, it will be more expensive.


For those entering a position like this, the higher price upon exercise will be worth the cost. Exercise will take place only if the price of the underlying has moved advantageously (share price of stock, for example).


Not commonly used for stock-based options, these are more likely to be found in speculative markets for currency exchange, interest rate options, and in other securities in the mortgage markets. In these markets, extending the life of an option may be advantageous if prices are moving slowly, but are expected to move with more volatility soon, perhaps due to seasonal influences or expected market developments.


The strategy employed by those trading in options on options combines a relatively inexpensive initial option (overlying) and extending its life with the second option (underlying). Because exercise will only occur when the overall position becomes favorably priced, the option on option is an economical alternative to buying a longer-term option. This becomes a type of insurance position because it reduces initial cost speculatively, assuming prices will move favorably and result in exercise (or that prices will not end up moving favorably, and the position just expires).


An expansion of the concept may involve a synthetic option on an option. For example, a speculator buys a CoC and sells a PoC at the same time. In this case, they probably will expire on the same date and with the same strike. This hedges the concept, but also means greater movement is needed to end up profitably (as is always the case with a synthetic position). In considering the potential as well as the risk of this approach, it should be clear that the complexity might not justify such a move. A more straightforward synthetic may provide the same benefits without as much risk because the ideal synthetic will be at or close to a zero net premium.


The complexity and risk level is even further complicated when an option on an option is sold rather than bought. This provides the trader with preferable cash flow but greater exercise risk, not to mention a double level of collateral required. The short option on option could be covered, but is true coverage accomplished with 100 shares per single option, or 100 shares for each of the two sides? The underlying is not activated by the seller in this case, but through exercise by the holder. For most traders, the risk exposure for a short option on option is too great and uncertain. However, hedging advantages through synthetics (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 will not be for everyone. In looking over the many complex and exotic variations on the basic idea of the option, the appeal often is the complexity itself. Too many traders have been drawn to complex positions like options on options because they are exotic and involve higher opportunity for profit (and equally higher risks). But the potential should be viewed realistically.


Just as a complex strategy like a box spread or butterfly is initially appealing, it contains limitations. The profit potential is there, but it is usually capped. The same is true in many applications of the option on option position. Premium costs and fees may erode part (or all) of the initial profit, which could be minimal at best.


Traders who find themselves drawn to exotic forms of option trades may be wise to take a step back before entering a trade. What is the true potential and risk involved? Given the complexity and just the 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? They would not. The same argument can be applied to the option on option and other exotic strategies. Traders might conclude that the appeal of complexity is not justified by what could be a limited profit with risk levels higher than risk tolerance.
 

In other words, after considering the option on option trade, one possible conclusion is that it makes more sense to buy (or sell) single calls or puts, with a clear understanding of the risks these more basic strategies involve.

Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Publishing as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.

 

 

 

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • Tips to Improve Your Trading in 2021

    Making investments can be an effective way to increase your capital and even generate an income, but it can take time to develop trading skills. Whether you’re new to trading or you’ve been playing the markets for some time, there’s always more to learn. If you want to improve your returns, take a look at these top tips to enhance your trading in 2021:

    By Kim,

    • 0 comments
    • 39 views
  • Binary Options: Proceed with Caution

    The binary option involves two possible outcomes, which are determined by whether the contract expires in the money. To profit from a binary option, a trader needs to be on the desired side. Exercise is automatic for these products, so that a profit or loss is added to or taken from the trading account immediately upon expiration.

    By Michael C. Thomsett,

    • 0 comments
    • 117 views
  • Enhancing 60/40 With a Short Strangle Overlay

    The classic 60/40 stock/bond portfolio has stood the test of time in both hypothetical and live fund results from multiple fund sponsors such as Vanguard, Fidelity, and American Funds. 60/40 balances enough in equities (60%) to generate long-term growth with enough in high quality bonds (40%) to manage downside risk.

    By Jesse,

    • 0 comments
    • 116 views
  • Getting Into Stocks and Shares Through the Pandemic Screen

    2020 and 2021 so far have been extremely difficult for many of us. Coronavirus and Covid-19 have spread across the world leaving havoc and chaos in their wake. We had to worry about the physical health of ourselves and our loved ones throughout this pandemic.

    By Kim,

    • 0 comments
    • 112 views
  • Selling LEAPS - Not as Attractive as Short-term Options

    The LEAPS (long-term equity appreciation securities) is an option that does not expire for as long away as 30 months or so, but is it a better alternative than shorter-expiring contracts? Traders selling covered calls may be attracted to the premium of 11 on an ATM strike, versus the less appealing 1.5 on a 2-week contract.

    By Michael C. Thomsett,

    • 0 comments
    • 307 views
  • Double Barrier Options

    The typical barrier option yields a payoff when the underlying reaches a predetermined price. Expanding on this idea is the double barrier option. This expansion of the barrier option is most applied to currency trading, indices, commodities, or OTC options, but not exchange-based trading.

    By Michael C. Thomsett,

    • 0 comments
    • 307 views
  • Barrier Options

    Some options produce a payoff if the underlying reaches a preset price. This is a great advantage of the barrier option because traders can expect profits (or worthless expiration) depending on the underlying behavior. The barrier refers to methods by which the underlying expires, as well as whether the price moves in the desired direction.

    By Michael C. Thomsett,

    • 0 comments
    • 395 views
  • First Time Trader? Here Are 3 Tax Tips You Should Know

    If you’re a first-time trader or this is your first year in the market, it’s important to know what to expect when it comes to your taxes. Now is the time of year to start thinking about your tax returns and what you’ll need to file. If just thinking about it gives you a headache, you’re not alone.

    By Kim,

    • 6 comments
    • 610 views
  • Solicitors (Or How do I make money on this?)

    My firm is frequently asked if it can pay people for referrals, and the short answer is “probably.”  The SEC calls third parties who send investment clients to investment advisors “solicitors,” and there is a specific rule governing solicitors and solicitor arrangements – SEC Rule 206(4)-3.

     

    By cwelsh,

    • 0 comments
    • 324 views
  • Lookback Options

    Most traders would agree that it would be a great advantage to decide whether to exercise an option with knowledge about past performance. Being aware of the odds an option will expire worthless gives the trader a significant advantage.

    By Michael C. Thomsett,

    • 0 comments
    • 457 views

  Report Article

We want to hear from you!


There are no comments to display.



Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs Expertido