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Capping Definition

What Is Capping?

Capping is the follow of promoting massive quantities of a commodity or safety near the expiration date of its options to forestall an increase within the underlying’s value. The author or vendor of an choices contract has an curiosity in preserving the worth of the underlying under the strike price for the choices to run out nugatory. If this happens, the choice writers preserve the premium collected.

Pegging is the complementary follow of shopping for massive quantities of a commodity or safety near the expiration date of its choices to forestall a decline in its value.

Key Takeaways

  • Capping is to actively promote the underlying safety of a spinoff to maintain it under the choice’s strike value.
  • Capping is labeled as a violation of securities legal guidelines if the promoting of the underlying is supposed to be manipulative. Reliable promoting previous to an possibility’s expiry is authorized.
  • Pegging is the other of capping, the place the underlying is purchased in an try to preserve the underlying’s value above the choice’s strike value.

Understanding Capping

Capping and pegging are types of market manipulation and due to this fact are in opposition to FINRA laws. Software program now detects this follow and crimson flags the violations.

Usually, an investor who may follow capping is a name possibility writer, though a put possibility purchaser has the identical curiosity. If training capping, the decision possibility author desires to keep away from having to switch the underlying safety or commodity to the choice holder. The objective is to have the choice expire nugatory to guard the premium initially obtained by the author. Subsequently, they might attempt to preserve the worth of the underlying under the strike value by promoting the underlying so as to add extra provide and preserve the worth down.

The decision possibility purchaser, however, desires the worth to rise above the strike value, as that may give the choice intrinsic value. If the underlying’s value is beneath the strike value, the choice is nugatory and the decision purchaser’s possibility has no worth at expiry. That is the state of affairs the decision author desires, which is why they might be motivated to take motion to maintain the worth of the underlying under the strike.

Capping Manipulation and Intent

Prohibitions in opposition to capping and different types of market manipulation are distinguished in securities coaching and licensing supplies. The Series 9/10 license is one instance. The Chartered Financial Analyst (CFA) syllabus additionally consists of the next language (topic to vary):

“Members and candidates should not interact in practices that distort costs or artificially inflate buying and selling volume with the intent to mislead market individuals.”

Amongst different practices—corresponding to ramping (artificially making a safety look extra voluminous or have extra motion than it truly does), pre-arranged trades, and outright falsehoods—it particularly mentions capping and pegging as manipulative practices.

Nonetheless, it additionally mentions that the intent of the motion is crucial in figuring out whether or not these are precise violations. There are reputable buying and selling methods that exploit variations in market info and different inefficiencies. Additionally, laws don’t prohibit shopping for and promoting choices and their underlying securities for tax functions.

Instance of Capping Choices

To illustrate that an investor sells a $190 name on Fb Inc. (FB) that expires in August and it’s presently June. The inventory is presently buying and selling at $185. The decision author receives a premium of $8.50, or $850 for every contract (controls 100 shares).

The choice author desires the choice to run out nugatory and never have it exercised by the choice purchaser. Exercising would require the author to ship shares to the client at a value decrease than the present market value.

If the Fb share value stays under the $190 strike value, at expiry the choice will likely be nugatory and the author will preserve the $850.

Assume that because the inventory approaches the expiration day, the inventory value is transferring very near $190 or barely above it. Choice writers—all of them, not simply this one—might promote shares that they personal, including to the provision of the inventory and hoping to push it again under or preserve it under $190. That is referred to as capping.

If the worth of Fb is above $190 on the August expiry, the choices will likely be in the money (ITM) for the decision patrons, which implies the writers might want to ship the inventory to the decision patrons at $190 even when the inventory is buying and selling at $195, $200 or greater than $250 on the open market.

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