Risk Latte - CBOE's Cap Calls

CBOE's Cap Calls

Rahul Bhattacharya
December 18, 2006

In 1991, the Chicago Board Options Exchange (CBOE) introduced a novel index option on the OEX and SPX indices. These options were call CAPs. A option was designed such that a CAP call will be issued at the money with the cap level placed 30 index points above the strike level. The exercise of the option will be automatic if the index - SPX or OEX - closes at or above the CAP level on any trading day up to an including the last day. The buyer of the CAP call then receives a payout of $30 times 100 - the size of a single option contract. This is like an American style barrier option.

The interesting thing to note about this index option is that when it was being introduced in 1991, the CBOE mistakenly compared the CAP call to a vertical call spread, where the buyer of the option is long a vanilla call with strike K and short a vanilla call with strike K + 30. Actually, this is only true at the expiry of the CAP call. The barrier feature, providing for the option's early exercise as soon as the CAP level is triggered is a strange one and it will give the short position a value lower than it would otherwise have in a vanilla call spread. The CAP is therefore worth more than a vanilla call spread.

It is hard to argue that CBOE didn't fully understand the product when it was introduced. But at the same time it seems strange that such misconception could arise in the Exchange's promotional announcement.

Reference :This is referenced from" Exotic Options: The Market and their Taxonomy" by Michael Ong and Team Latte shall not be responsible for any errors and omissions contained in the above. .

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