Capping is a complicated process that involves selling options on an underlying asset and then selling the asset aggressively to prevent the price from rising. This usually results in a profit
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Options trading can be complicated. Not only is the derivative itself a little hard to get your head around, trading strategies and “tricks” to make as much money as possible are even more complex.
In this article, we’re going to talk about a similar strategy in options trading called capping. We’re going to explore what it means, how traders use these strategies, and whether it leads to a profit or not.
Understanding capping in the share market
Capping in stock investing refers to the practice of actively selling a stock short-term to prevent its price from rising above a specific level, typically done by the writer (seller) of an options contract.
Now, let’s unpack some terms in that definition one by one.
- Selling a stock short-term: This means either selling securities that you already have or shorting the asset – which is borrowing the securities from someone else to sell in the hope of buying back the same asset from the market at a lower price.
- Specific level: In this context, the specific level is the strike price of the options contract. In a call option, this is the price at which you have the right to buy the asset from the option writer. In the case of a put option, the right is to sell at the strike price.
- Writer (seller) of the options contract: Just like in every other transaction, options trading also involves two parties – the buyer of the option and the seller. In this case, the “writer” of the option is the seller of the option.
Understanding how capping works with an example
Imagine you’re an options seller and believe a stock X is overvalued. You decide to sell (write) a call option for X with a strike price of ₹100 per share. This means the option buyer has the right to buy the stock from you at ₹100 per share by the expiry date.
Here is where the capping part of the strategy comes in:
- The strategy: When you fear that X’s price might move past ₹100, in which case you have to essentially pay the difference in the price, you start to sell X stocks aggressively on the open market.
- Increased supply: To sell this stock, however, you have to short it, which means you have to borrow it from someone who is willing to lend. By doing this, you increase the supply of X in the market for the short-term.
- Downward pressure: This increased supply, considering demand is constant, will drive down the price of the stock. Ideally, the price should stay below ₹100.
- Outcome: If the capping strategy works and X stays below ₹100 by expiry, the call option becomes worthless. The buyer won’t exercise their right to purchase the stock at ₹100 because they can buy it cheaper in the open market. You, the options seller, keep the premium you received for selling the call option without any obligation to deliver the shares.
While the strategy might seem straightforward, there are multiple ways in which it could go very wrong for you.
Limitations of the capping strategy
Here are some things you need to keep in mind if you’re considering the capping options trading strategy:
- The legality of the mechanism: While capping itself isn’t illegal, it can get you into trouble with the authorities or regulators like SEBI if done in a manipulative way. They could also choose to prosecute you for an attempt to artificially manipulate the stock price for personal gain. SEBI and other regulators are constantly on the lookout for such activities to ensure fair market practices.
- Risks: You could also dig your own grave by capping too aggressively. If the stock price rises despite the selling pressure, you could suffer a huge loss both on your options and your short selling.
Capping vs. Pegging
Pegging is the opposite strategy, where the option seller actively buys the stock to prevent its price from falling below the strike price. Both capping and pegging are considered interventionist strategies and should be approached with caution.
Frequently Asked Questions
No. Market forces can overpower your selling pressure, and the stock price might still rise. You could end up losing money if you have to buy back shares at a higher price.
While anyone can sell a stock, capping is typically used by options sellers who want to manage their risk from selling call options. It’s not a recommended strategy for regular stock investors.
Yes. Options sellers can use strategies like buying protective put options or delta hedging to manage their risk. These strategies are generally considered less risky and manipulative.
Not directly. Capping aims to keep the price below the strike price. However, you might benefit indirectly. If capping keeps the price down and the option expires worthless, you keep the premium you received for selling the call option.
Unusual trading activity with a sudden increase in selling pressure could be a sign of capping. However, pinpointing the exact reason for such activity can be difficult in most cases.