A capped call (or capped option) is an option that automatically sells a stock if the price goes beyond or below some predetermined price. A capped call caps your gains but is cheaper than a normal option.
A capped call can also be used as an option to sell at a certain price. It’s different from an automatic sell order that you issue to your brokerage firm since you don’t have to sell it at the specific price by not exercising your option. On the other hand, an automatic sell order will be done once the price level has been attained.
An example where you would use a capped call
Let’s take an example:
- Company Name: Apple
- Expected Price Increase: 10%
- Capped Call Sell Price: 10% increase
- Price Of Capped Call: $500
- Price Of Normal Put Option: $5,000
When you buy a stock, you typically hope for its stock price to increase significantly. But what if you only expect the stock price to increase modestly, say 10%?
Say that you expect Apple’s stock price to increase by 10%. You don’t have to spend $5,000 to buy an expensive put option or the stock itself. Instead, you might only want to purchase some option that automatically sells if the stock price increases beyond a certain amount. With capped calls, you would be able to get the same 10% gains (if you’re right) at only $500 instead of $5,000.
If the stock price of Apple were to increase by 50% instead, you would have lost out on the 40% increase because your capped call was automatically exercised at the 10% limit. Obviously, the cheaper cost (i.e. less risk) comes at the price of missing out unexpected gains.
above some predetermined price.
