compound option



  • An investment instrument in which the underlying position is another option. This "option on another option" is usually used to manage risk within currency and fixed income markets. The worth of a compound option depends largely on the potential profit from the first option and offers additional leverage at a lower cost. There are four basic variations: call on call, call on put, put on a call, and a put on another put. This creates two expiration dates and two strike prices for each type of compound option. A foreign company placing a bid (in USD) to provide goods or services to a U.S. company might purchase a compound option to ensure that the value of the payment they eventually receive is equal to the current exchange rate even if the value of the dollar decreases in the interim.