What is Capping?

Derivatives like futures and options help investors attain profits in the volatile share market Sometimes, the occurrence of manipulation trading deceives traders. Unfortunately, not every trade can be closely scrutinized by the regulators to demonstrate the proof of legitimacy. These forms of manipulations oscillate the share price of the companies in the market.

According to FINRA, any kind of illegal activity in the share market is considered a violation of the securities act. Capping in the share market is one of the below-the-belt practices in trading. The opposite of this practice is pegging in the share market, which is also illegitimate in the eyes of the securities act. This blog highlights a bigger picture of what is capping in the share market and further aspects related to it.

What is Capping in The Share Market?

Generally, in options, the buyer has the right to purchase or sell the commodity or security at a predetermined price on a set date. The advantage options claim is that the buyer is entitled to an obligation to either buy or sell. Exercising this right is in the hands of the buyer. The options deal ceases after the expiry date. The price mentioned on the options contract is known as the strike price.

Now, capping in the share market is the process of selling the asset before the options expire to fend off the spike in the price of the underlying. The idea of the seller is to make the options contract valueless and good for nothing by keeping the underlying asset or commodity price lower than the strike price. This results in allowing the options writers to capture the premium. The vice-versa practice of capping in the share market is pegging. Here, the buyer purchases a huge volume of commodities before the expiry of the options deal to impede the plunge in the prices.

As per The Financial Industry Regulatory Authority (FINRA), a self-regulatory authority that oversees the securities markets and exchanges, any kind of manipulation of the trades is termed an unethical violation. Capping and Pegging, both these practices are illegitimate, as they deceive the investors into wrong buying and selling activities. Besides, the upgrade in the technology aids regulators in identifying the red flags upon misdemeanours in the share market.

The seller is called the call option writer and the buyer is called the put option writer. Both the practices are inclined to circumvent transferring the commodity to the respective buyer/seller and secure the premium received. Hence, the goal is to keep the underlying asset price underneath the strike price of the option.

When it comes to the buyer options writer, the deal is worthy only if the price of the underlying asset is beyond the strike price. In case, if the deal doesn’t meet the criteria, the options contract will be of no use and the premium also gets wasted. Conversely, this is exactly what call option writers lookout for to seize the opportunity to gain an unfair advantage over price manipulations.

Capping Manipulation and Intent

If a trader misleads the other by conducting wrongful acts, it’s a form of manipulation. All such deceiving acts are prohibited in nature as per securities and licensing aspects. For instance, Series 9/10 is an entrance exam designed to make a person into a supervisor who oversees the sale of securities. This entrance exam is managed by FINRA, and once you pass the exam, you will be looking after all the activities like the sale of corporate securities, money market funds, mutual funds, etc. Capping and pegging are termed illicit practices. Additionally, ramping and pre-planned options trades are also considered illegal acts.