What is Capping?

Capping is the practice of selling large amounts 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 expire worthless. If this occurs, the option writers keep the premium collected.

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

Key Takeaways

  • Capping is to actively sell the underlying security of a derivative to keep it below the option's strike price.
  • Capping is labeled as a violation of securities laws if the selling of the underlying is meant to be manipulative. Legitimate selling prior to an option's expiry is legal.
  • Pegging is the opposite of capping, where the underlying is bought in an attempt to keep the underlying's price above the option's strike price.

Understanding Capping

Capping and pegging are forms of market manipulation and therefore are against FINRA regulations. Software now detects this practice and red flags the 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 option 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. Therefore, they may 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, on the other hand, wants the price to rise above the strike price, as that will give the option intrinsic value. If the underlying's price is beneath 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 wants, which is why they may be motivated to take action to keep the price of the underlying below the strike.

Capping Manipulation and Intent

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

"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 (artificially making a security look more voluminous or have more movement than it actually does), pre-arranged trades, and outright falsehoods—it specifically mentions capping and pegging as manipulative practices.

However, it also mentions that the intent of the action is critical in 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 Options

Let's say that an investor sells a $190 call on Facebook Inc. (FB) that expires in August and it is currently June. The stock is currently trading at $185. The call writer receives a premium of $8.50, or $850 for each contract (controls 100 shares).

The option writer wants the option to expire worthless and not have it exercised by the option buyer. Exercising would require the writer to deliver shares to the buyer at a price lower than the current market price.

If the Facebook share price remains below the $190 strike price, at expiry the option will be worthless and the writer will keep the $850.

Assume that as the stock approaches the expiration day, the stock price is moving very close to $190 or slightly above it. Option writers—all of them, not just this one—could sell shares that they own, adding to the supply of the stock and hoping to push it back below or keep it below $190. This is called capping.

If the price of Facebook is above $190 at the August expiry, the options will be in the money (ITM) for the call buyers, which means the writers will need to deliver the stock to the call buyers at $190 even if the stock is trading at $195, $200 or more than $250 on the open market.