More Pegging and Capping of Options

Options Trading Topic: More Pegging and Capping

Dear Options Trading FAQ:

Hi. I know an options research firm that often talks about out-of-the-money call option accumulation at certain strikes that can act as resistance for a stock. The theory behind that, I thought, is that the market makers who sold those calls will hedge by buying other calls and sell stock whenever the stock gets close to moving above the level with the high call accumulation to try to keep those calls out-of-the-money.

But then, I had a trader and a market maker call me and tell me that that is not usually the case and that the market maker doesn't even care where the stock is really. I'm very confused. What am I missing? Should I be a...

Conspiracy Theorist or Trusting Soul? An avid options trader.

Dear Always be Both as an Options Trader:

Ah, the ever-present whispers of stock manipulation. Traders with large option positions have great incentive to influence the price of the stock (especially at expiration). One of the most popular Options Trading FAQ columns dealt with the tendency for stocks to land exactly on their strikes on expiration day. If you would like a reprint of the "Coincidence or Conspiracy" Q&A from Oct 25, 1995, please e-mail me.

Some background: Trader Blair Hull (interviewed in The New Market Wizards by Schwager pg.385) says that there is a natural tendency for stocks to finish at the strike. He did some statistical work that was quoted in the WSJ. A stock is about twice as likely to finish within a 1/4 point of the strike price at an option expiration than might be expected.

Why is this? As mentioned, it was covered in my previous Q&A on option trading, but basically there is great incentive to do so. The particular option strategies require a close to the strike finish in order to maximize profit. This can be done through "natural" tendencies or by outright manipulation such as pegging or capping. In your example, selling shares of stock to purposely keep the stock below a certain strike is called capping. There are rules expressively forbidding this activity, so it can be a touchy subject.

To answer your question more directly, the option trader and market maker are right. This sort of case is rare. What happens most of the time is that the market makers set their hedges at the onset of the positions. That is, when they have to buy or sell to meet a public order, they lay off the risk on the spot. They would adjust their portfolio either in other options or in the stock itself (long or short). They will keep the hedge going as well as they can so that movement in the stock will not hurt them (delta neutral). The risk to them comes in the form of a large gap opening where they don't have a chance to adjust the hedge (out of kilter).

There have been (and always will be) cases where the market maker will try to peg or cap the stock at the expiry. Blair Hull laughs at a recollection: "When I was a trader on the PSE, two smaller mm's wanted to pin the price of a particular stock to the strike. They wanted to sell the stock on the expiration date and make sure that all the calls and puts went out worthless. They enlisted the aid of a large market maker in this scheme. The large market maker agreed to join their group and pin the stock. Instead, he took the opposite position and took them both out of the game."

This sort of stuff is unusual but the potential may exist when certain calls or puts accumulate. Maybe that is what your option research firm is talking about. It makes for an interesting report by the analyst, but I would side with the trader and the market maker on this. In fact, in most things, one should usually trust the guys and gals "downstairs" more than the fat cats "upstairs".

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Valuation, Options Pricing

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