COMPOUND OPTION

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Graphical Representation of Option Price and Sensitivities

Compound option may be described simply as an option on an option.
There are four types of compound options: a call on a call, a put on a call, a put on a put, and a call on a put.
Compound options have two strikes and two exercise dates.
Let us consider an example a call on a call.
Let T₁ be the time at which we can, if we wish, exercise the compound option to purchase the underlying vanilla option for an amount X₁.
This underlying option may be exercised at time T₂ for an amount X₂
in return for an asset with price S.
Hence the payoff function is max(C(S,T₁)-X₁,0).

Four types of compound option:

1. a Call on a Call, the payoff is max(C(S,T₁)-X₁,0).
2. a Put on a Call, the payoff is max(P(S,T₁)-X₁,0).
3. a Put on a Put , the payoff is max(X₁-P(S,T₁),0).
4. a Call on a Put , the payoff is max(X₁-C(S,T₁),0).

The first Option on Option model was published by Geske (1977)
Other research has been by Hodges and Selby (1987) and Rubinstein (1991)

Pricing Models Page Available is a Swing Java Jar File if you just wish to run the models.