Capped Call

An options strategy often purchased by companies issuing convertible debt to minimize potential dilution if their stock price rises.

A capped call is a private derivative transaction that a company enters into with financial institutions, typically at the same time it issues convertible debt. The primary purpose of a capped call is to protect the issuing company and its existing shareholders from the dilutive impact of the debt converting into equity. When a company issues convertible bonds, it gives bondholders the right to convert their debt into shares of stock at a predetermined conversion price. If the stock price rises significantly above this conversion price, the company must issue a large number of new shares, which dilutes the ownership and earnings per share of existing investors. By purchasing a capped call, the company effectively buys call options on its own stock with a strike price that matches the conversion price of the convertible debt, while simultaneously selling call options at a higher "cap" price. If the stock price rises, the payout from the capped call offsets the cost of delivering shares to the bondholders, up to the cap price. This structure effectively raises the conversion price from the perspective of the company, reducing the dilution that occurs as the stock price climbs. For retail investors, a company's decision to purchase a capped call is generally viewed as a positive signal. It demonstrates that management is actively taking steps to protect shareholder value and minimize dilution. However, investors should be aware that these transactions do not completely eliminate dilution if the stock price rises above the cap. Additionally, the purchase of a capped call requires an upfront cash outlay, which is typically funded using a portion of the proceeds from the convertible debt offering.

Company A issues convertible notes with a conversion price of $50 per share. To protect against dilution, Company A purchases a capped call with a lower strike price of $50 and a cap price of $75. If the stock price rises to $70, the gains from the capped call offset the dilution cost of issuing shares to bondholders. However, if the stock price climbs to $90, the dilution protection ceases to operate for the portion of the stock price above the $75 cap, meaning the company will experience standard dilution on the $15 difference between the cap and the market price ($90 - $75 = $15).