Call on a Put
How it works (Example):
Let's look at an example to illustrate the concept.
If you own a call on a put on Company XYZ stock with a July 31 expiration date, you would have the right but not the obligation to exercise by July 31 the call option to purchase a put option to sell 100 shares of Company XYZ by, say, December 31 at $15 per share. Once you own the underlying option, you have until December 31 to decide whether to sell the shares of Company XYZ at $15 per share.
Note that the value of a call on a put depends on the value of the underlying option. In our example, if Company XYZ shares are trading at $25 right now, the value of the underlying December 31 option is probably $0 and thus the July 31 option is also probably worth $0.
However, if Company XYZ shares are trading at $5, the value of the underlying option has value (since it doesn't expire until December 31), and so the July 31 option probably has some value as well. In general, the value of the put option increases as the value of the underlying Company XYZ stock decreases. And as is the case with any put option, the investor will generally exercise a call on a put if the strike price ($15) is higher than the market price of the stock.
Why it Matters:
Though our example uses shares, compound options are more common in bond and currency markets. Companies may also use them when 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 gain from compound options.
The premiums on options are 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.