What is a 'Capped Option'

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

For a 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.

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.

BREAKING DOWN 'Capped Option'

Capped options are one type of derivative that provides and upper and lower boundary for possible outcomes. While this 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.

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 options. Both options have the same expiration date.

For example, in a bull call spread, the investor buys a 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 tradeoff 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 limited profit potential and lower cost to purchase.

One strategy to manage volatility is called a collar. This is 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.

RELATED TERMS
  1. Early Exercise

    Early exercise is the process of buying or selling shares under ...
  2. Call On A Call

    A type of compound option in which the investor has the right ...
  3. Aggregate Exercise Price

    The strike price of a put or call option multiplied by its contract ...
  4. European Option

    An option that can only be exercised at the end of its life, ...
  5. Exercise Backdating

    A practice where option holders fraudulently claim to have exercised ...
  6. In The Money

    1. For a call option, when the option's strike price is below ...
Related Articles
  1. Trading

    Dividends, Interest Rates and Their Effect on Stock Options

    Learn how analyzing dividends and interest rates is crucial to knowing when to exercise early.
  2. Trading

    Exploring European Options

    The ability to exercise only on the expiration date is what sets these options apart.
  3. Investing

    What are Options Contracts?

    An explanation of options contracts, call options and put options.
  4. Trading

    Trading Options on Futures Contracts

    Futures contracts are available for all sorts of financial products, from equity indexes to precious metals. Trading options based on futures means buying call or put options based on the direction ...
  5. Trading

    What Is Option Moneyness?

    Get the basics under your cap before you get into the game.
  6. Taxes

    How Are Stock Options Taxed & Reported?

    That depends on the type of stock option you have. A rundown of the tax treatment for statutory and nonstatutory, or non-qualified, options.
RELATED FAQS
  1. How do I change my strike price once the trade has been placed already?

    Learn how the strike prices for call and put options work, and understand how different types of options can be exercised ... Read Answer >>
  2. After exercising a put option, can I still hold my option contract in order to sell ...

    Once a put option contract has been exercised, that contract does not exist anymore. A put option grants you the right to ... Read Answer >>
Hot Definitions
  1. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
  2. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its current share price relative ...
  3. Internal Rate of Return - IRR

    Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments.
  4. Limit Order

    An order placed with a brokerage to buy or sell a set number of shares at a specified price or better.
  5. Current Ratio

    The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations.
  6. Return on Investment (ROI)

    Return on Investment (ROI) is a performance measure used to evaluate the efficiency of an investment or compare the efficiency ...
Trading Center