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FD/U3 Topic 10 Chooser Option, Compound Option, Basket Option

Chooser Option

A chooser option is an option contract that allows the holder to decide whether it is a call or put prior to the expiration date. Chooser options usually have the same exercise price and expiration date regardless of what decision the holder ultimately makes. Because they don’t specify that the movement in the underlying asset be positive or negative, chooser options provide investors a great deal of flexibility when evaluating volatile issues.

Chooser options offer the holder the flexibility to choose between a put or a call. These options are typically constructed as a European option with a single expiration date and strike price. The holder has the right to exercise the option only on the expiration date.

A chooser option can be a very attractive instrument when an underlying security reports a high level of volatility or when there is uncertainty around a highly followed corporate development. For example, one might be wise to select a chooser option on a biotech company awaiting the Food and Drug Administration’s reaction to its latest wonder drug or any company facing litigation.

Compound Option

An option to purchase an option. Examples include, a call on a call option or a call on a put option. A fee must be paid to buy a compound option and a second payment must be made to the owner of the option in the event the compound option is exercised. Also called split-fee option.

Let’s assume John Doe buys a call on an option to purchase 100 shares of Company XYZ at $25 per share by March 31. He pays $1,000 to the seller of that call. This arrangement is called a compound option — that is, it is an option to purchase an option.

Now let’s say John Doe wants to exercise the call on the option. Now he must pay the premium on the second option (the option to buy 100 shares of Company XYZ at $25 per share). This second premium, called the back fee, is $3,900.

Many investors know that they don’t always have to make outright purchases or sales of securities; they can also use puts and calls. But few investors know about compound options, which can be very useful but carry back fees.

Back fees are very much like fees paid to extend the life of an option. Though they represent an added expense, the broader picture is that the compound options they associate with offer a way for investors to “ride” a stock without investing as much capital as would be required for buying or selling the stock outright. This does not come without risk, however.

Basket Option

A basket option is a financial derivative, more specifically an exotic option, whose underlying is a weighted sum or average of different assets that have been grouped together in a basket. For example, an index option, where a number of stocks have been grouped together in an index and the option is based on the price of the index.

Unlike a rainbow option which considers a group of assets but ultimately pays out on the level of one, a basket option is written on a basket of underlying assets but will pay out on a weighted average gain of the basket as a whole.

Like rainbow options basket options are most commonly written on a basket of equity indices, though they are frequently written on a basket of individual equities as well. For example, a call option could be written on a basket of ten healthcare stocks, where the basket was composed of ten stocks in weighted proportions.

The strike price Xbasket is usually set at the current value of the basket (at-the-money), and the payoff profile will be max(Sbasket − Xbasket, 0) where Sbasket is a weighted average of n asset prices at maturity, and each weight represents the percentage of total investment in that asset.

Basket options are usually priced using an appropriate industry-standard model (such as Black–Scholes) for each individual basket component, and a matrix of correlation coefficients applied to the underlying stochastic drivers for the various models. While there are some closed-form solutions for simpler cases (e.g. two-color European rainbows), semi-analytic solutions, analytical approximations, and numerical quadrature integrations, the general case must be approached with Monte Carlo or binomial lattice methods.

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