Tuesday, February 25th, 2020

Trading Capped Style Options


Trading capped style options provides options sellers with a limit to their downside risk while putting a cap on potential profits for a seller. In theory, one can engage in trading either American style options or European style options while trading capped style options. Capped style options act like a circuit breaker while not necessarily interfering with the ability of a trader to execute a contract at a time of his or her own choosing. When trading capped style options, there is a profit cap as part of the options contract. Let us say that price of the underlying rises to a given point in a call option contract. The contract is automatically exercised by the terms of the contract. If that contract is for a put and the price drops to a predetermined price the contract is also exercised. How does trading capped style options affect the trader?

Less Price Volatility Leads to Lower Contract Prices

Writing options is commonly more profitable over the long run than buying options. This is because sellers set prices and only sell when the odds of profit are strongly in their favor. However, there is always a risk of significant loss in writing options because the seller of an options contract is obliged to comply with the terms of the contract no matter how badly he fares in the trade. Trading capped style options reduces the risk of loss for the seller of an options contract and, as such, reduces the price needed to purchase an options contract. The basic options trading tools are the same for capped style options as they are for other types of options. And, the cap on an options contract must be factored in to the equation for both fundamental and technical analysis. To the extent that an options trader can get into trades at a lower price and reliably gain a reasonable profit, trading capped style options can be profitable as it increases his leverage on the vast majority of options trades.

Picking Options with the Right Cutoff

To a degree the amount of profit that a trader can make in trading capped style options is related to picking options with an ideal cutoff. A smart trader will pick options where he expects to gain a profit. To the extent that he expects there to be a huge move in stock, commodity, or Forex price he must take into account that the cap will take hold and limit his profits. A contract in which this is likely to happen is likely an expensive options contract. To the extent that there is likely to be less price movement the options contract price may be very small. Many may choose to trade the inexpensive contracts in search of a greater profit multiple than what might occur in a contract likely to reach its cap. In trading capped style options traders must follow the same general practices as with trading all options. Sound fundamental and technical analyses are necessary to guarantee the best chances of success.

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