Alan Ellman, a featured speaker at this week’s Forex & Options Expo, explains how “pinning” of options should be considered when writing covered calls.
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 p.m. EST on expiration Friday, a phenomenon known as pinning the strike may take the price to or slightly above the strike as trades are finalized, even a few minutes after 4 p.m..
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 often get “pinned” at $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 toward 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.
Some theories as to the cause of pinning:
- 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.
- Dynamic hedging by institutional traders who are seeking delta-neutral trades.
OK, we’re going to need some review of definitions here, so brew up a mug of high-octane coffee!
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 and a put option will approach a delta of -1.
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. Long calls and long puts both always have positive gamma. Short calls and short puts both always have negative gamma.
Positive gamma means that the delta of long calls will become more positive and move toward 1 when the stock prices increase, and less positive and move toward 0 when the stock price declines. It means that the delta of long puts will become more negative and move toward -1 when the stock price falls, and less negative and move toward 0 when the stock price rises. The reverse is true for short gamma.
For example, the BCI March 50 call has a delta of +.45, and the BCI March 50 put has a delta of -.55, with the price of BCI at $48. The gamma for both the BCI March 50 call and put is .07. If BCI moves up $1 to $49, the delta of the BCI March 50 call becomes +.52 (+.45 + ($1 x .07), and the delta of the BCI March 50 put becomes -.48 (-.55 + ($1 x .07). If BCI drops $1 to $47, the delta of the BCI March 50 call becomes +.38 (+.45 + (-$1 x .07), and the delta of the BCI March 50 put becomes -.62 (-.55 + (-$1 x .07).
Next: Hedging
|pagebreak|Hedging
A type of transaction that limits investment risk using derivatives, such as options and futures contracts. Hedging transactions purchase opposite positions in the market in order to ensure a certain amount of gain or loss on a trade. They are used by portfolio managers and institutional investors to reduce portfolio risk and volatility or lock in profits.
Stock movement and delta:
Click
to Enlarge
Influence of Gamma
Pin pressure comes from “gamma traders” attempting to remain delta neutral. Since gamma (rate of change of delta for every $1 change in the stock price) increases as we get closer to expiration Friday, traders tend to buy and sell many more shares of stock to stay delta neutral and ensure little to no risk.
Example
- BCI Corp. is trading at $50 per share
- The dealer (market maker) is long 100 x $50 calls, which have a delta of .50 and a gamma of .14. This means that the delta will change by .14 for every $1 change in share price.
- The dealer is also long 100 x $50 puts, which have a delta of -.50 and a gamma of .14. Once again, the delta will change by .14 for every $1 change in share price.
- The dealer is currently delta neutral: (100 calls x .50 delta) + (100 puts x -.50) = 0. (Take another sip of that coffee!)
- If the stock moves up $1, the new delta position will be 28: (100 calls x .64) + (100 puts x -.36) = 28 (call and put delta move up by .14).
- As a result of this $1 increase in share price, the dealer must sell 2,800 shares of BCI Corp. to remain delta neutral.
To Roll or Not to Roll
If your stock is trading just under the strike sold at we approach 4 p.m. EST on expiration Friday, and it meets the criteria for potential pinning, consider rolling the call position if your decision is to keep this stock for the next contract cycle. The cost to close (time value) will be minimal ($0.50 - $0.10) as 4 p.m. EST approaches on expiration Friday.
Conclusion
The evidence suggests that pinning is real and unique to high-open-interest options on expiration Friday. It is impacted by the hedging forces that are normal market forces used by institutional traders to eliminate risk from their portfolios.
Alan Ellman can be found at TheBlueCollarInvestor.com.
