Capping and pegging are forms of “mini-manipulation,” a type of market manipulation involving simultaneous trading in both options and their underlying stock or future.
An option writer seeking to avoid the option holder exercising or assigning the option aggressively trades the underlying stock or future near the close on the settlement date (selling if he wrote a call option to push the underlying down (capping), buying if he wrote a put option to push the underlying up (pegging)), thereby increasing the chance that the option will expire worthless.
In the above example (click to enlarge), an option writer is short the May 19, 2017 $16 put for symbol APLP. On the settlement date, if the underlying stock closes at $16 or above, the $16 put option will expire worthless, but if the stock closes below $16, the option writer will be obligated to sell the stock for less than its market value, incurring a liability for the writer and generating a profit for the holder. The writer of the $16 put thus wants the underlying to close at or above $16. In this example, he encourages that result by aggressively buying the underlying during the final two minutes of market hours on the settlement date. As a result of (at least in part) his buying, the underlying closes at $16.02, and the $16 put option expires worthless.
Other forms of mini-manipulation also involve aggressively trading the underlying stock or future to increase the value of a derivative options position, but at times and prices other than near the strike price on the settlement date.
Capping & pegging or other forms of mini-manipulation were the subject of FERC’s enforcement action against Amaranth Advisors and CFTC’s enforcement action against Total Gas, both in natural gas futures, as well as the CBOE’s enforcement actions against HAP Trading and Lime Brokerage, and the SEC’s and FINRA’s pending enforcement matters against Lek Securities.
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