Tuesday, February 25th, 2020

Trading Compound Options


An options trading style similar to the Russian dolls that nest inside one another is trading compound options. Trading compound options is trading an option on an option. In trading compound options there are two exercise dates. As with trading European style stock options the first contract is only exercised at maturity. In the case of a call contract the buyer will exercise the option if the price of the underlying equity has gone up sufficiently above the strike price of the contract. If the price of the equity is not high enough at maturity the contract is still exercised but in such a way as to give the buyer a second chance in trading compound options. The prices in trading compound options reflect the second chance aspect of having two back to back chances for a profit.

Calls and Puts in Trading Compound Options

In trading this trading style one still follows profitable options strategies by analyzing both fundamentals and technical factors. A call in either the first or following option gives the buyer the right to exercise the options contract and purchase the underlying equity no matter how high the price might go up. A put gives the buyer the right to sell the underlying equity no matter how low the market price might fall. In each case the buyer is under no obligation to execute the contract and will do so only if it is profitable. The difference in trading compound options is the second chance aspect of the second contract. If in a call contract the price does not rise sufficiently the options contract is exercised and a second contract takes its place. The same happens with a put contract.

Contract Duration and Time Value

The time value of an options contract comes from the fact that anything can happen in a volatile market. The longer the time that remains until contract expiration the more that can happen. The potential back to back aspect of trading compound options gives rise to double the time value of a contract. Depending on the exact nature of the contract in trading compound options, it may be possible to exit the contract during either the first or second phase. This is typically done by simply executing the opposite trade on the same equity with the same set of expiration dates. If the value of the contract in either its first or second phase has risen the buyer will make money and if not he or she will exit in order to contain losses. In trading compound options as in other options styles the seller of the options contract is obligated to fulfill his end of the bargain and sell in the case of a call or buy in the case of a put if the buyer so chooses. Over the long run selling options tends to be more lucrative than buying them. However, there is always the risk of a big loss when selling options, which commonly limits the business of selling options to those with deep pockets. Practical options trading tactics should always apply whether one trades compound options or other styles.

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