Capping

What Is Capping?

Capping is the practice of selling large measures of a commodity or security close to the expiration date of its options to prevent a rise in the underlying's price. The writer or seller of an options contract has an interest in keeping the price of the underlying below the strike price for the options to lapse worthless. Assuming that this happens, the option writers keep the premium collected.

Pegging is the complementary practice of buying large measures of a commodity or security close to the expiration date of its options to prevent a decline in its price.

Understanding Capping

Capping and pegging are forms of market manipulation and subsequently are against FINRA regulations. Software currently distinguishes this practice and red banners the violations.

Typically, an investor who could practice capping is a call option writer, albeit a put option buyer has a similar interest. In the case of working on capping, the call option writer needs to abstain from moving the underlying security or commodity to the option holder. The goal is to have the option terminate worthless to safeguard the premium initially received by the writer. Subsequently, they might try to keep the price of the underlying below the strike price by selling the underlying to add more supply and keep the price down.

The call option buyer, then again, needs the price to rise over the strike price, as that will give the option intrinsic value. Assuming the underlying's price is underneath the strike price, the option is worthless and the call buyer's option has no value at expiry. This is the scenario the call writer needs, which is the reason they might be persuaded to make a move to keep the price of the underlying below the strike.

Capping Manipulation and Intent

Forbiddances against capping and different forms of market manipulation are noticeable in securities training and licensing materials. The Series 9/10 license is one model. The Chartered Financial Analyst (CFA) prospectus additionally incorporates the accompanying language (subject to change):

"Individuals and applicants must not participate in practices that distort prices or falsely swell trading volume with the intent to deceive market participants."

Among different practices —, for example, inclining (misleadingly making a security look more voluminous or have more movement than it really does), pre-arranged trades, and outright misrepresentations — it specifically specifies capping and pegging as manipulative practices.

In any case, it likewise specifies that the intent of the action is critical in deciding if these are real violations. There are authentic trading strategies that exploit differences in market data and different failures. Likewise, regulations don't disallow buying and selling options and their underlying securities for tax purposes.

Instance of Capping Options

Suppose that an investor sells a $190 call on Meta, formerly Facebook Inc., (META) that lapses in August and it is currently June. The stock is currently trading at $185. The call writer gets a premium of $8.50, or $850 for each contract (controls 100 shares).

The option writer believes that the option should lapse worthless and not have it [exercised](/work out) by the option buyer. Practicing would require the writer to deliver shares to the buyer at a price lower than the current market price.

On the off chance that the Meta share price stays below the $190 strike price, at expiry the option will be worthless and the writer will keep the $850.

Accept that as the stock methodologies the expiration day, the stock price is moving exceptionally close to $190 or somewhat above it. Option writers — every one of them, in addition to this one — could sell shares that they own, adding to the supply of the stock and expecting to push it back below or keep it below $190. This is called capping.

Assuming that the price of Meta is above $190 at the August expiry, the options will be in the money (ITM) for the call buyers, and that means the writers should deliver the stock to the call buyers at $190 even on the off chance that the stock is trading at $195, $200 or more than $250 on the open market.

Features

• Capping is to actively sell the underlying security of a derivative to keep it below the option's strike price.
• Pegging is something contrary to capping, where the underlying is bought trying to keep the underlying's price over the option's strike price.
• Capping is named as a violation of securities laws on the off chance that the selling of the underlying is intended to be manipulative. Authentic selling prior to an option's expiry is legal.