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ELI5: What is a capped call?

Capped calls are a financial strategy used to limit the risk of investing in a particular stock or asset.

ELI5

Imagine you have a toy that you really like, but you’re worried that it might break if you play with it too much. So you make a deal with your friend: you’ll let them play with your toy, but only for a certain amount of time. After that, they have to give it back to you.

Capped calls work kind of like that. When you buy a stock or an asset, you can buy a capped call option at the same time. This option puts a limit, or a cap, on how much money you can lose if the stock or asset goes down in value.

Here’s an example:

Let’s say you buy 100 shares of a company’s stock at $10 per share. You’re worried that the stock might go down in value, so you also buy a capped call option that sets a limit on how much money you can lose. The cap is set at $12 per share.

If the stock goes up in value, you can sell your shares for a profit. But if the stock goes down in value, you can exercise your capped call option and sell your shares for $12 per share, no matter how low the stock price goes. This way, you limit your potential losses while still having the opportunity to make a profit if the stock goes up in value.

In short, capped calls are a way to protect yourself from potential losses while still participating in the potential gains of a particular investment.

This sounds like an automatic sell order. What’s the difference?

Capped calls are similar to automatic sell orders in that they allow you to automatically sell an asset at a certain price. However, there are some differences between the two:

  • Capped calls are an options contract that you purchase, while automatic sell orders are instructions you give to your broker to sell an asset at a certain price.
  • With a capped call, you have the option to sell the asset at the capped price, but you don’t have to. You can choose to hold onto the asset and sell it at a later time if you think the price will go up. With an automatic sell order, the asset will be sold automatically if the price hits a certain level.
  • Capped calls are often used to limit potential losses on an investment, while automatic sell orders are used to lock in profits or limit losses.

Capped calls can be seen as a more flexible tool for managing risk and protecting investments, while automatic sell orders are a more straightforward way to set and forget a sell price for an asset.