Call on a Call
How it works (Example):
Unlike regular calls, which offer the right but not the obligation to purchase an underlying asset, calls on calls offer the right but not the obligation to purchase a call. So, for example, if you owned a call on a call on Company XYZ stock that expires on, say, July 31, you would have the right but not the obligation to exercise by July 31 an option to purchase an option to buy 100 shares of Company XYZ by, say, December 31 at $25 per share. Once you own the underlying option, you have until December 31 to decide whether to purchase the shares of Company XYZ at $25 per share.
Note that the value of a call on a call depends on the value of the underlying option. In our example, if Company XYZ shares are trading at only $15 right now, the value of the underlying December 31 call option is probably $0 and thus the July 31 call on a call option is also probably worth $0.
However, if Company XYZ shares are trading right at $25, the value of the underlying call option may have some value (since it doesn't expire until December 31), and thus the July 31 call on a call probably has some value as well. In general, the value of the option increases as the value of the underlying Company XYZ stock increases. And as is the case with any call option, the investor will generally exercise the call option (both of them) if the strike price is below the market price of the stock.
Why it Matters:
Though our example uses stocks, compound options are more common in bond and currency markets. However, companies might also use them when they're hedging their bets on other things (bids for contracts, potential buyers, key accounts) that may or may not happen. Also, investors who simply think that a volatile stock, bond, or currency might head in a certain direction in the future might benefit from compound options.
The premium on options is usually a fraction of the price of the underlying security, and this ability to earn big profits (or losses) with little up-front cash is one of the most notable characteristics of options. Compound options magnify the already significant effects of this relationship.