What is 'Capping'

Capping is the practice of selling large amounts of a commodity or security close to the expiration date of its options in order to prevent a rise in they underlying's price. The writer or seller of an options contract has an interest in keeping the price of the underlying below the options strike price in order for the options to expire worthless. In this case, the options writer keeps the premium collected.

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

BREAKING DOWN 'Capping'

Capping, and pegging, are forms of market manipulation and therefore are against FINRA regulations. Software now detects this practice and red flags violations.

Typically, an investor who might practice capping is a call option writer although a put option buyer has the same interest. If practicing capping, the call options writer wants to avoid having to transfer the underlying security or commodity to the option holder. The goal is to have the option expire worthless to protect the premium initially received by the writer.

Prohibitions against capping and other forms of market manipulation are prominent in securities training and licensing materials, for example, the Series 9/10 license. The Chartered Financial Analyst (CFA) syllabus includes the following language:

"Members and candidates must not engage in practices that distort prices or artificially inflate trading volume with the intent to mislead market participants."

Among other practices, such as ramping, pre-arranged trades and outright falsehoods, it specifically mentions capping and pegging.

However, it also mentions that the intent of the action is critical to determining whether these are actual violations. There are legitimate trading strategies that exploit differences in market information and other inefficiencies. Also, regulations do not prohibit buying and selling options and their underlying securities for tax purposes

Example of Capping

Let's say that an investor sells a $50 call on XYZ common stock that expires on June 30th and receives a $100 premium. Option sellers want the option to expire worthless and not have it exercised by the option buyer, requiring them to deliver shares to the buyer at a price lower than the current market price. If the stock price falls in price below $50 per share, the option buyer lets the option expire worthless and sells the stock in the market. If the option seller sells the underlying stock close to the expiration date of its options, the stock may decrease in price therefore causing the option to expire worthless.

RELATED TERMS
  1. Listed Option

    A listed option is a derivative security traded on a registered ...
  2. Time Decay

    The ratio of the change in an option's price to the decrease ...
  3. Currency Option

    A contract that grants the holder the right, but not the obligation, ...
  4. Capped Option

    A capped option limits, or caps, the maximum profit for the holder ...
  5. Asian Tail

    An option feature whereby a reference price is activated at the ...
  6. Premium Income

    1. In investing, income that is earned through the sale of an ...
Related Articles
  1. Trading

    Options Strategies for Your Portfolio to Make Money Regularly

    Discover the option-writing strategies that can deliver consistent income, including the use of put options instead of limit orders, and maximizing premiums.
  2. Trading

    Google Stock Too Expensive for You? Try Options

    Learn how to invest in Google (now Alphabet, Inc.) and other high-value stocks with less capital by using options.
  3. Trading

    How to Sell Put Options to Benefit in Any Market

    Put selling can be a lucrative strategy as long as you're willing to own the underlying security.
  4. Investing

    Is it Risky to Invest in Options?

    Investing with options can be a great strategy, but you need to do your research first or the risks can outweigh the benefits.
RELATED FAQS
  1. When does one sell a put option, and when does one sell a call option?

    An investor would sell a put option if her outlook on the underlying was bullish, and would sell a call option if her outlook ... Read Answer >>
  2. How is a put option exercised?

    Learn the process, and what happens, when you exercise a put option. Also read about alternatives to exercising an option. Read Answer >>
  3. Does the seller (the writer) of an option determine the details of the option contract?

    The quick answer is yes and no. It all depends on where the option is traded. An option contract is an agreement between ... Read Answer >>
Hot Definitions
  1. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  2. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
  3. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  4. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
  5. Dividend

    A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.
  6. Inventory Turnover

    Inventory turnover is a ratio showing how many times a company has sold and replaces inventory over a period.
Trading Center