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.
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.
