OPTIONS

The phenomenon known as pinning to the strike price is fairly common among high open interest options on expiration Friday, and Alan Ellman of TheBlueCollarInvestor.com explains what it is, why it happens, and what you should do if it hits your covered call position.

When considering covered call exit strategies on- or near-expiration Friday we compare the market price of our stock to the strike price sold. If the share value is even one penny above the strike, the option will most likely be exercised and our shares sold. We may not want this to occur and we may therefore consider a rolling strategy. If the price is slightly below the strike as we approach 4:00 pm EST on expiration Friday, a phenomenon known as pinning the strikemay take the price to or slightly above the strike as trades are finalized even a few minutes after 4:00 pm.

Definition and Background
There is a tendency for stocks to close very close to a strike price with a large open interest on expiration Friday. For example, if a stock is trading near the $50 strike which also has huge open interest, it will oftentimes get “pinned” @ $50 on expiration Friday. This is called “pinning the strike”. This has everything to do with the Max Pain Theory,which states that the underlying security will tend to move towards the price where the greatest number of options contracts (in dollar value) will expire worthless. In other words, it is the point where option owners feel the maximum pain and option sellers capture the greatest reward.

Theories as to the Cause of Pinning
1. Conspiracy theory:
This theory states that market makers use their immense firepower to manipulate share price to close at the strike so as to capture maximum profit as options expire worthless. In my view, it would take an immense conspiracy by the most powerful of institutional investors to accomplish this and then go undetected by the recently improved vision of the regulators. I give little or no credence to this point of view.

2. Dynamic hedging by institutional traders who are seeking delta-neutral trades. Okay, we’re going to need some review of definitions here so brew up a mug of high-octane coffee…I’ll wait for you…

Take a sip, here we go!

  • DELTA - Ratio amount that an option value will change for every $1 change in the underlying security. Call options have deltas between 0 and 1. Put options have deltas between 0 and (-) 1. For example, if a call or put option has a delta of .5, it will rise or fall $0.50 for every $1 change in the price of a stock. If a stock goes up $1, a call option will rise by $0.50 and a put option will fall by $0.50. As a call option nears expiration Friday it will approach a delta of 1.00 and a put option will approach a delta of (-) 1.00.

  • DELTA NEUTRAL - This is a portfolio consisting of positive and negative delta positions, which balance out to bring the net change to zero. Institutional traders use delta neutral positions to eliminate risk from their positions.

  • GAMMA - This is the rate of change of delta with respect to a $1 change in the underlying security. It is a second generation delta, if you will.

NEXT PAGE: Examples to Illustrate