Is it possible to have "options on options"? Does such a trading vehicle exist? Here is a paper on such option types, but I'm not sure if such financial products exist yet: http://www.global-derivatives.com/i...ticle/13-options-database/31-compound-options Alternatively: how else could one create a chain (gear) of such products? Ie. if the premium of the 1st level option rises a specified level, say 50%, then this shall trigger the 2nd level option... Goal is to be able to create multiple levels of such options and thereby have a multiplication factor effect...
You used to be able to get them OTC, but they were expensive and not very popular (I'd know best, given that I used to make markets in that sh*t). And obviously there is no added leverage effect given the cost, you just as well might trade options farther OTM.
Options on options should be much cheaper than normal options, and from that point of view I think they should become popular if marketed well by the big firms, not OTC. I believe one can create very powerful strategies with such vehicles, ie a kind of "chain reaction", x levels wide. Unfortunately it seems the time is not ripe yet for them.
Could you define "much cheaper" and define what exactly you mean by options on options (do you have a payoff in mind)? The ones you refer to (calls on calls, for example) were marketed by big firms for big firms and still were not very popular. Barriers (up/out or down/out) are far more popular as cheap options go.
Here's an example for 3 levels. In this example we are interessted in ATM Call options. It somehow should be feasable, I think, but level 2+ should IMO be non-traded options, ie. static options that one can buy for a price that is calculated realtime using the BS formula, ie. price not determined by bid/ask but by the BS formula. Level2+ are linked to the normal option (level 1 option). The level 1 option is a normal option, and is the main player, all the other levels are optional and "static". How the wanted multiplication effect on the outcome should look like is missing yet in this example... this will follow soon... just brainstorming... Ideas & opinions welcome ------------------------------------ Level 1 option: Normal Call Option Option Id XXX-1 Underlying XXX Price of Underlying 100 Exercise Price 100 Days Until Expiration 30 Volatility% 25 Interest Rate% 5 Dividend Yield% 0 --> Theoretical Price Call Option 3.01866 Theoretical Price Put Option 2.69071 ------------------------------------ Level 2 option: Option on the above Call option Option Id XXX-2 Underlying XXX-1 Price of Underlying 3.01866 Exercise Price 3.01866 Days Until Expiration 30 Volatility% 25 Interest Rate% 5 Dividend Yield% 0 --> Theoretical Price Call Option 0.09112 Theoretical Price Put Option 0.08122 ------------------------------------ Level 3 option: Option on the above level 2 option Option Id XXX-3 Underlying XXX-2 Price of Underlying 0.09112 Exercise Price 0.09112 Days Until Expiration 30 Volatility% 25 Interest Rate% 5 Dividend Yield% 0 --> Theoretical Price Call Option 0.00275 Theoretical Price Put Option 0.00245 ------------------------------------
What makes you think you can even use the same volatility (and apparently, the same model ) for the compound options? Even if you disregard the modelling aspects (e.g. critical stock price), you should at least assume that realized volatility of an option is going to be a combination of volatility resulting from the stock price (approximately delta * underlying volatility / option price) and volatility resulting from the changes in implied volatility (which would approximately be vega * volatility of implied volatility / option price) plus some correlation factor that correlates these two. Obviously, that would make it very expensive and the lower the base option price, the higher the volatility would be.