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 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 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
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.