Compound Option comes in the form of call on a call, call on a put, put on a put and put on a call. This Compound Option requires two types of premium are associated with two strike prices and two expiration dates.Compound Option can be best described as an option on an option.
Generally, Compound Option comes in four basic forms. These basic forms are called put on a put, put on a call, call on a call and call on a put.All these basic forms of Compound Options are associated with two expiration dates and two strike prices. Between the two expiration dates, one is tagged with Compound Option and the other is tagged with underlying option.
Similarly, among the two strike prices, one is fixed for Compound Option and another one is associated with the underlying option.Compound Option carries two types of option premiums.
One serves as the paid up front for the compound option. Another option premium is paid for the underlying option, in the event of exercising the compound option. In case of exercising the Compound Option, the total amount of the combined premiums, may exceed the level of premium that is required for buying the underlying option at the very start. The value of the Compound Option is very volatile.
The Compound Options carry with them Vanilla Options. These vanilla options offer an advantage by allowing the option to be extended. In this case, the option can be extended beyond the expiration date. For, this reason, these are also called Extendible Options.
These Extendible Options come in two forms. One is Holder Extendible Option and the other is Writer Extendible Option. In case of Holder Extendible Option, the holder enjoys the right to pay additional premium at expiration of the option, with the objective of postponing the expiration date. On the other hand, in case of Writer Extendible Option, automatic expansion of the expiration date takes place, in the event, when the option faces out-of-the-money condition. The process requires no additional premium.