Capping is a strategy that is employed in an attempt to keep the price of a stock low or force the price to move lower than the current position. An approach of this type is sometimes attempted with commodities or securities that are getting close to an expiration date, with the goal being to at least prevent the price from increasing, which would result in the commodity posting little if any profit for the investor. Many associations and trade organizations consider this type of activity to be unethical and have regulations encouraging members to avoid engaging in any strategy that involves capping.
One of the more common examples of how capping works is to consider a security that is about to reach its expiration date. In order to drive the price down, the dealer may choose to sell significant amounts of the security on the open market, effectively creating market congestion that causes investors to wonder what is about to happen with the security. As investors hold back to see what will happen with the security next, the price either remains stagnant or may even decrease a bit as few buyers step up to purchase the large number of shares on the market.
What capping accomplishes in this scenario is to impact the delivery of the underlying security after the expiry date is reached. Specifically, the investor who holds the call option on the security is attempting to avoid having to transfer the security to the option holder. By driving the price downward, the option may be worthless once the expiration date is reached, which means the underlying security does not change hands and the premium that the call option writer received at the time the option was created is safe.
Since capping involves an attempt to artificially influence market movements, many investment professionals question the integrity of this type of activity. In some nations, trade associations and similar organizations have gone so far as to address this issue in the rules and regulations that their members pledge to follow in order to receive and maintain membership. For example, the National Association of Securities Dealers or NASD has very strict rules regarding capping that prohibit members from utilizing this tactic. In the event that a member of NASD is found to be using this approach, he or she may lose standing and privileges in the organization and could possibly be removed from membership altogether.