If you are looking into learning more about the concept of “exotic options,” one of the strategies worth exploring is the capped put. But what is a capped put, and how does it work? This article breaks down capped puts, their transactions, and how they manage risk while keeping costs lower.
Key takeaways
- The capped put strategy is a risk management tool that combines limited profit potential with reduced costs, making it ideal for investors anticipating moderate declines in asset prices.
- Capped puts automatically exercise when the underlying asset reaches the cap price, offering a unique way to control risk while reducing the premium compared to standard put options.
Capped Options – What Are They and How Do They Work?
Capped options are a type of derivative, offering a predefined limit on profits in exchange for lower costs. They differ from standard call and put options by automatically exercising once the cap price is reached.
For example, a capped put exercises if the underlying asset’s price falls to or below its cap. These options combine capped outcomes with reduced premiums, making them ideal for managing risk during moderate market movements. The cap interval determines the range between the strike price and the cap price.
Similar to vertical spreads, capped puts transactions provide bounded outcomes, balancing cost efficiency with limited gains.
What is a Capped Put?
So, what is a capped put? We told you a bit about capped options, but it’s time to be a little more specific. A capped put is a type of options contract that gives the holder the right to sell an underlying asset at a predetermined strike price. The key difference? A capped put automatically exercises when the asset’s price reaches a pre-set level, called the cap price, offering limited downside protection in a cost-effective way.
Here’s how it works: The cap price acts as a boundary on the potential loss or profit. For instance, if the cap price is $40 and the asset drops to $40 or lower, the capped put will exercise automatically. This feature makes capped puts appealing for investors who expect moderate declines in asset prices without the need for aggressive hedges.
Why use capped puts? They come with clear benefits:
- Lower costs: Since the profit potential is limited, buyers pay reduced premiums compared to standard put options.
- Risk mitigation: Sellers benefit from greater predictability, avoiding extreme losses in volatile markets.
A simple example could look like this: Imagine you hold a capped put with a strike price of $50 and a cap price of $40. If the price of the asset drops to $38, the option automatically exercises at $40, limiting your gains but ensuring a quick hedge.
Capped puts transactions are particularly useful in low-volatility markets. They allow institutional investors to hedge moderate downward movements without taking on high costs. As a note, consider that capped puts are exotic options, which are not suitable for retail investors. However, if you’d like to replicate its setup as a spread, you can do so on our options screener.
These strategies are comparable to others like vertical spreads, where cost and profit are both bounded, or protective collars, which also aim to manage risk. However, capped puts stand out for their automation and simplicity.
Finally, consider that, while these strategies are always interesting, you will normally see them performed by large institutions on OTC (over-the-counter) markets. Still, capped puts can offer a fascinating way to think about risk management, even if you are not planning to use them (as it’s probably the case) in your own investment strategy.
