Capped Option:Definition, How It Works, Benefits

What Is a Capped Option?

A capped option limits, or caps, the maximum possible profit for its holder. When the underlying asset closes at or beyond a specified price, the option automatically exercises.

For capped call options, the option exercises if and when the underlying closes at or above the predetermined level. Similarly, capped put options exercise if and when the underlying closes at or below the predetermined level.

How a Capped Option Works

Capped options are one type of derivative that provides an upper and lower boundary for possible outcomes. The difference between the strike price and the boundaries is known as the cap interval. While this boundary limits the profit potential for the holder, it comes at a reduced cost. Therefore, if the holder believes the underlying asset will move modestly, capped options provide a good vehicle to capture it. To arrive at the option's cap price for a call, add the cap interval to the strike price. For a put, subtract the cap interval from the strike price. 

Another name for capped options is capped-style options. Conceptually, capped options are similar to vertical spreads where the investor sells a lower priced option to partially offset the purchase of a higher priced option. Both options have the same expiration date.

For example, in a bull call spread, the investor buys call options with one strike price while also selling the same number of calls of the same asset and expiration date but at a higher strike. Because the second call is farther from the current price of the underlying, its price is lower. The two trades together cost less than the outright purchase of the calls. However, the trade off is a limited profit potential.

Other Similar Strategies

The major benefit for capped options is to manage volatility. Buyers believe the underlying has low volatility and will move only modestly. Sellers want to protect against big movements and high volatility. Of course, for the seller the trade-off for volatility protection is lower premiums collected. And for the buyer, it is the reverse with a limited profit potential and a lower cost to purchase.

One strategy to manage volatility is called a collar. This is a protective options strategy for the holder of an underlying asset through the purchase of an out-of-the-money put option while simultaneously selling an out-of-the-money call option. A collar is also known as hedge wrapper.

Range forward contracts are common in the currency markets to hedge against currency market volatility. They are zero-cost forward contracts that create a range of exercise prices through two derivative market positions. A range forward contract is constructed so that it provides protection against adverse exchange rate movements while retaining some upside potential to capitalize on favorable currency fluctuations.

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