Call on a Call

What Is a Call on a Call?

A call on a call (CoC, or CaCall) is a type of exotic option that gives the holder the right to buy a call option on the same underlying. Essentially, a call on a call option is an option to buy an option. It will have two strike prices and two expiration dates. One is for the compound call option, and the other is for the underlying vanilla option.

The call on a call is one of four types of compound options, also known as split-fee options or options on options. The others are: call on a put (CaPut); put on a put; and put on a call.

How a Call on a Call Works

Call on a call options are a type of exotic option with customized terms that trade on alternative exchanges. With a call on a call option, the holder has a secondary call option which gives them the right but not the obligation to buy a plain vanilla call option with specified terms at a specified price.

A call on a call can be beneficial to an investor if it is offered at an optimal price. The holder of the secondary call has the right but not the obligation to buy a plain vanilla call. Generally, call on a call options are structured with American exercise. Thus, the investor has until the expiration date to exercise the secondary call. The secondary call and plain vanilla call can be exercised simultaneously or separately.

If the investor exercises the compound call simultaneously, then they believe the plain vanilla call is in the money and at its most profitable peak. When both compound options are exercised, the investor receives the underlying call option which is then immediately exercised for receipt of the underlying security. If the compound option holder chooses to only execute the first leg of the contract, then they will receive the plain vanilla call option at its specified expiration and exercise price for future enactment.

In some cases, a call on a call option can be used by an investor to extend their exposure to an underlying asset at a low cost. Many options allow a roll feature that provides for extended exposure, but a call on a call option may allow this at a lower cost. For example, if the compound call holder finds the price of the underlying call option to be beneficial to their investment plans, they may exercise the first leg of the option to obtain the plain vanilla option with a future expiration date.

Pricing a Call on a Call

Before expiration, the value of the plain vanilla option will depend on the value of the asset the underlying option represents. In the options market, investors may use several methodologies to calculate the value of their option. The Merton model is one method that has been introduced for compound options.

A compound call on a call option is a complex option that carries higher costs (premiums) than vanilla options. The investor will also be required to pay a transaction cost that factors in the execution of both options. The cost of the compound option is important to consider as it can decrease the profitability of the investment overall.

Other Compound Options

The other three types of compound options are:

These options are also known as split-fee options.

Real World Application

While speculation in the financial markets will always be a major portion of compound option activity, business enterprises might find them useful when planning or bidding on a large project. In some cases, they must secure financing or supplies before actually starting or winning the project. If they do not build or win the project, they could be left with financing they do not need. In this case, compound options provide an insurance policy.

The same is also true for lenders, as they seek to hedge their exposure should they commit to providing the money needed by businesses for their projects, and those businesses do not win their deals.