Like the Wall Street equivalent of a hat on a hat. There are call options (predicting the price of an asset will go up) and put options (predicting the price will go down) but there are also exotic options. (Sounds like something you might find on a South Seas Island.) A call on a call is a type of exotic option where an investor buys a secondary call option that gives him or her the right to buy a regular, "plain vanilla" call option at a particular price on a security.
The "underlying" asset of a plain vanilla call option could be a stock, a bond, a commodity or a foreign currency, while the underlying asset of a secondary option is always another option. The two calls can be traded at the same time or separately.
Why would an investor want to construct such a seemingly complicated deal? Sometimes they want to use a call on a call to extend the time they have to see where prices are headed on the underlying asset. He or she could exercise the secondary option in order to buy the plain vanilla one that has a later expiration date.
Using a call on a call can be a more expensive strategy (see Alligator Spread) as there will be two transaction costs for the execution of both the secondary and plain vanilla options. Also, it's a hugely volatile play...but when you're right, you can win huge...like 100x your money in a month kind of huge. Here's to having had good Karma in a past life.
Related or Semi-related Video
Finance: What Is a Put Option?83 Views
finance a la shmoop what is a put option? hot potato hot potato
ow ow! yeah remember that game well nobody wanted the potato, poor thing. the
players wanted to put it in someone else's hands. well put options kind [glue put around a flaming potato]
of work the same way. a put option is the right or option or choice to sell a
stock or a bond at a given price to someone by a certain end date.
all right example time. you bought netflix stock at the IPO a zillion years
ago at $1 a share. that's you know splits adjusted. all right now it's a hundred
bucks a share. if you sell it you pay taxes on a gain of 99 dollars a share. in
California that would be a tax of something like almost 40 bucks. well the
stock was a hundred but you keep only something like 60. feels totally unfair.
right so you really don't want to sell your stock but you're nervous about the [graph shown]
next few months that Netflix will crater for a while and go down ten
maybe twenty dollars. longer term though you think it'll hit 300. so this is the
perfect setup to maybe look at buying some put options on Netflix. if the stock
goes down your put options go up. with Netflix volatile but at a hundred bucks
a share ,you look up the price of an $80 strike price put option expiring in
December, and you know that's mid-september now .for five bucks a share
you can protect your stock for the next few months .think about it like temporary [stocks placed in vault]
term life insurance. you pay the five dollars a share in the stock goes down
to 82 by mid December, worst of all worlds. well not only did you lose the $5
a share but your stock has lost $18 in value. but had Netflix really cratered
and gone to say $60 a share well you would have exercised your put and sold
your shares at 80 bucks. well those put options you paid $5 for
would be been worth 15 bucks a share. in buying that put option you've [equation shown]
guaranteed that your loss will be no more than a $75 value for your Netflix
position at least for that time period and ignoring taxes. well remember that
options expire after December whatever like the third Friday of the month it's
usually when options expire, you then have no protection and your shares float
along naked. naked? really who knew accounting could get so [paper put option goes "skinny dipping".]
raunchy. yeah well that's naked put options.
that's what they really are people.
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What is a strike price? Strike prices are used in conjunction with options. Calls and puts give investors the right to buy or sell stocks at predet...