Front Fee

What Is a Front Fee?

The front fee is the option premium paid by an investor upon the initial purchase of a compound option. A compound option is one where the underlying asset is likewise an option; it is an option on an option. The front fee gives the investor the right, yet not the obligation, to exercise the initial option to receive the underlying option. Whenever exercised, one more fee known as the "back fee" is payable for the underlying option's premium. Note that the subsequent choice might be exercised to make a last transaction in the underlying asset itself.

For example, you could buy a compound option to buy a call on euros. On the off chance that you exercise the compound option, this gives you the right to buy euros at a pre-set exchange rate at or before a certain point of time has elapsed. Assuming you exercise that subsequent choice, you acquire the euros.

Grasping Front Fees

Compound options are utilized in circumstances where uncertainty exists in regards to the requirement for risk relief. For instance, a company might present a bid for an overseas project. If effective, the project would generate critical revenue in a foreign currency, which might should be hedged against exchange rate risk. A compound option would be helpful in this case, on the grounds that the front fee payable would be lower than the premium payable on a foreign currency option contract. They purchase an option to buy a foreign currency option, and afterward they just have to utilize the initial option (to receive the underlying one) if necessary and beneficial to do as such.

Compound options come in four arrangements:

• Call on a put, called a CoP (CaPut), is the right to buy a specific put option.
• Call on a call, called a CoC (CaCall), is the right to buy a specific call option.
• Put on a put, called a PoP, is the right to sell a specific put option.
• Put on a call, called a PoC, is the right to sell a specific call option.

The option premium associated with the purchase of both of these four arrangements would be the front fee and is paid to the seller of the compound option. For instance, if and when a call on a put is exercised, the option holder will purchase a put and pay the premium for that option as the back fee.

Illustration of a Front Fee in a Compound Option Stock Trade

An illustration of a front fee is pay $6 for two call-on-a-call option contracts in Apple Inc. (AAPL). The contracts give the right to purchase AAPL 250 strike calls with an expiry in 90 days. The stock is right now trading at $225. For the two contracts, the cost is $1,200 ($6 x 200 shares, since each contract is for 100 shares).

This is a less expensive strategy whenever the chance of the stock rising above $250 inside the next 90 days is low. The premium that would need to be paid for the three-month 250 calls outright would be $27 per contract, or $5,400 ($27 x 200 shares)

Typically, compounded options are not utilized in options on stocks or equity indexes. They are generally utilized in currency or fixed income markets where firms have weakness or uncertainty in regards to the requirement for an option's risk protection.

Another common business application that compound options are utilized for is to hedge bids for business projects that might possibly be accepted.

Features

• The option-on-an-option gives a lower upfront cost and more flexibility than purchasing protection straightforwardly (which may not be required).
• A compound option is successfully an option to buy or sell another option, like a call on a put or a put on a put.
• The premium on the underlying option's contract, or back fee, would possibly be paid assuming that the compound option is exercised.
• The front fee alludes to the premium outlay for the initial purchase of a compound option.