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What is a Front Fee?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 13 September 2016
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A front fee is a charge that is assessed on at the beginning of the purchase of some type of compound option. This up-front premium is only the first charge to be assessed and normally represents one portion of the total purchase price. Typically, a second premium is assessed and tendered by the buyer at a later date, with that second premium being known as a back fee.

This first premium payment on an options contract makes it possible to take advantage of the unique structure of a compound option. Essentially, this type of option is one option that is built onto another option. There are several ways to arrange this type of investment strategy, with one example being to call on a put option, which involves exercising an option to buy an option with the intent to sell one or more of the underlying assets. In order to arrange this to best effect, the investor pays the premium on the first option, with this fee known as the front fee, then arranges for the sale of that underlying asset. Once that deal is in place, it is an easy matter to then pay the premium on the second option, which is known as the back fee, complete the strategy and recoup all investment and possibly realize a return.

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This type of split-fee option contract is a relatively common approach, and works well for the investor. At each point in the process, the amount of the total investment is kept within an acceptable range, and also allows the investor to minimize the amount of risk he or she is assuming up to that point. Once the investor makes arrangements to sell the underlying asset, typically at a profit, the resulting revenue stream should be enough to offset the front fee as well as the back fee, and position the investor to earn a decent return from the venture.

As with most investment strategies, the selection of the investments to use in compound options is key to earning a return. This normally means looking closely at the nature of the underlying assets, and determining how they will hold their value for at least the amount of time required to complete the entire process. Ideally, the front fee should also be as modest as possible, allowing the investor to tie up less of his or her capital during the progression of the option strategy, and increase the chances of recouping the front fee with no problem.

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