What Is a Put on a Put?

One of the four types of compound options, a put on a put is a put option on another underlying put option. The buyer of a put on a put has the right – but not the obligation – to sell the underlying put option (also known as the vanilla option) on the expiration date. This type of option is also known as a split-fee option.

Put on a Put Explained

When an investor buys a put option, he has the right to sell the stock or underlying security before the expiration date. Most put options allow an investor to sell 100 shares of stock to the person who sells him the put option. In the case of a put on a put, it involves two put options – one over the other.

Characteristics of a Put on a Put

A put on a put has two strike prices and two expiration dates – one for the initial compound put option and the other for the underlying vanilla put option. Note that compound options are generally European-style exercise, which means they can only be exercised on the expiration date. On the contrary, an American-style option can only be exercised before the date of expiration.

Since one of the variables that determine the cost of an option is the price of the underlying asset, the cost of a put on a put option will generally be lower than the cost of a put on the corresponding asset. It can thus provide a great deal of leverage to the options trader.

When to Use a Put On a Put

A put on a put option is used when a trader wants leverage. The trader will also be moderately bullish on the underlying asset. The value of a put on a put changes in direct proportion to the price of the underlying asset. This means the value increases as the asset price increases, and decreases as the asset price decreases.

Other Compound Options

The other three types of compound options:

  • Call on a put: This type of option refers to a setup where there is a call option on an underlying put option. If the owner exercises the call option, he receives a put option.
  • Call on a call: In this option, the investor buys another call option with customized provisions. These provisions give him the option to buy a plain vanilla call option on an underlying security.
  • Put on a call: When exercising this option, the investor must deliver the underlying call option to the seller and collect a premium based on the strike price of the overlying put option.

These options are also known as split-fee options.