A Capped Style Option or Covered Option is an options contract with an upper-profit limit or a profit cap. An option is automatically exercised if the underlying asset reaches the capped level, slashing any future profits. Capped Style Options are used to cover risks and secure potential profits.
Key Characteristics of Capped Style Options:
- Profit Cap: The profit on the option is capped at a specified value.
- Automatic Exercise: The option automatically exercises when the capped threshold is attained.
- Risk Mitigation: The internal cap safeguards the writer from heavy losses.
Key Benefits of Capped Style Options:
- Risk Management: The options are favoured by hedge fund managers since they cap potential losses.
- Simplified Trading: Automatic exercise minimises the necessity for continuous market monitoring.
- Lower Premiums: In comparison to conventional options, capped style options are cheaper in terms of premiums since profit is capped.
Drawbacks of Capped Style Options:
- Capped Gain Potential: Profits are capped, and thus, the gains are less when the underlying asset is good.
- Opportunity Cost: If the asset exceeds the capped level, the investor foregoes additional gains.
Applications of Capped Style Options
- Hedging: A preferred option for hedge funds to avoid sudden market fluctuations.
- Limited Risk Speculation: They are employed in short-term strategies with managed exposure.
- Portfolio Protection: They are employed to hedge profits in current positions.
Conclusion:
Capped style options are an investment strategy for individuals who want to limit risk without completely sacrificing market upside potential. While they limit profit, their built-in protection makes them attractive to conservative investors and hedge fund managers as well.
