Capping

Deciphering Capping and Pegging in Options Trading

In the intricate world of options trading, there exists a strategy known as capping, a practice employed to manipulate the price of a security close to the expiration date of its options. But what exactly does capping entail, and how does it impact the market? Let's delve deeper into this phenomenon and uncover its nuances.

What is Capping?

Capping involves the deliberate selling of significant amounts of a commodity or security nearing the expiration date of its options. The primary objective behind capping is to prevent the underlying asset's price from rising above the strike price of the options. This maneuver is particularly advantageous for the writer or seller of the options contract, as it ensures that the options expire worthless, allowing them to retain the premium collected.

Conversely, pegging serves as the counterpart to capping, involving the acquisition of substantial quantities of a security or commodity nearing the options' expiration date to prevent its price from declining.

Key Takeaways:

Capping aims to sell the underlying security of a derivative to keep it below the options' strike price.
It is considered a violation of securities laws if conducted manipulatively.
Pegging, on the other hand, involves buying the underlying to keep its price above the options' strike price.

Understanding Capping

Capping and pegging are classified as forms of market manipulation and are subject to regulatory scrutiny. Advances in software technology have enabled the detection of such practices, allowing authorities to flag potential violations promptly.

Typically, investors who engage in capping are call option writers, although put option buyers may share a similar interest. Call option writers seek to avoid transferring the underlying security or commodity to the option holder by allowing the options to expire worthless. To achieve this, they may resort to selling the underlying asset, thereby increasing its supply and suppressing its price below the strike price.

Conversely, call option buyers anticipate the underlying asset's price to surpass the strike price, rendering the options valuable. Thus, the call writer's objective aligns with keeping the asset's price below the strike price to render the options worthless at expiry.

Capping Manipulation and Intent

Regulations and industry standards, such as those outlined by FINRA and prominent licensing examinations like the Series 9/10, explicitly prohibit market manipulation practices, including capping and pegging. These regulations emphasize the importance of discerning the intent behind such actions.

While capping and pegging may appear manipulative, legitimate trading strategies exploit market inefficiencies without the intent to mislead market participants. However, the line between permissible trading activities and manipulative practices can sometimes blur, necessitating vigilance from market regulators.

Example of Capping Options

To illustrate capping in action, consider an investor who sells a call option on a popular stock, such as Meta (formerly Facebook Inc.), with a strike price of $190 and an expiry date in August. If the stock is trading below $190 as the expiration date approaches, the call option will expire worthless, allowing the writer to retain the premium received.

In anticipation of the stock's price nearing the strike price as the expiry date looms, option writers may strategically sell shares to suppress the stock's price, thereby ensuring the options expire out of the money.