What is a call on a call?
Using compound options is a common way for investors to hedge their bets on stock, bond or currency, as the fees or premium on options are usually much lower than the price of the underlying security. Through this mechanism, investors could limit losses or earn big profits with little up-front cash.
The four types of compound options are puts on puts, puts on calls, calls on puts and call on a call. Compound options such as a call on a call give more flexibility to investors.
Having a call on a call means the holder has the right to buy a call option on the underlying asset at an agreed price within a specified time frame. In regular calls, holders have the right but not the obligation to buy a derivative-based security. The holders of a call on a call option have the right but not the obligation to purchase a call.
Financial information site Investopedia defines call on a call as “an option to buy an option”.
A call on a call option will have two strike prices and two expiration dates, one for the compound call option, the other for the underlying option for the security.
How does call on a call work?
An investor can buy a call on a call option, but the price of this option will depend on the value of the underlying option. In general, the value of the call option will mirror the value of the underlying security.
With the call on a call option explained, let’s take a look at an example.
If an investor owns a call on a call on Company ABC’s stock that expires on 31 May, they would have the right but not the obligation to exercise, by 31 May, an option to buy an option to buy 1,000 Company ABC’s shares at $15 per share by 30 November. After exercising the compound option by 31 May, the holder would have until 30 November to decide whether to purchase the 1,000 Company ABC shares at $15 per share.
If the stock price of Company ABC increased to $20 per share before 30 November, the investors would probably exercise both call options, as the strike price of $15 is below the market price of the stock.
In contrast, if the stock price of Company ABC fell to $10 per share before the option expires on 30 November, the investor would likely not exercise his call option to buy the 1,000 Company ABC shares and limit their loss to the price paid for the call on call option.