A cap is an options protection strategy where you simultaneously have a short position on a stock and a long call for the same underlying asset. Adding a long call to your open position means that you are obligated to buy your stock at the strike price. However, you already have a short position on the asset, which means this call option will help you close your position on the stock by buying back the shares at a fixed price. You will gain the difference from the short stock and the long call. The combination of those two products creates a payoff that is like a long put. However, the profit is not the same since you spent more on a cap versus a put option.

What are its components?

A cap has two components:

  • Short Stock
  • Long Call

When and why should I have a cap?

You should have a cap if you are bearish on a stock and wish to have an extra protection in case the price of the stock goes up. By adding a long call to your long position, you are willing to reduce your profit should the stock price decrease to create a ‘cap’, which is the lowest profit you can attain if the price is higher than the strike price.

What is the payoff and profit graph?

What is the break-even point?

The break-even point of a cap can be defined by finding the stock price where the cap generates a zero-dollar profit. By adding the short stock and long call together and equating it to zero, you should solve for ST.

About Kevin Smith

Kevin is the content manager for Personal Finance Lab and is from Chicago, Illinois. He has a Master's Degree in Economics from Concordia University in Montreal, Canada. In addition to an economics background, he has also built training manuals to prepare finance companies for licensing requirements in mortgage loan origination and insurance sales.