The phenomenon of stock pinning to a strike around options expiration is frequently witnessed occurrence. Some have waived the “conspiracy” flag. In a sense this is “market manipulation” but it’s not as nefarious as you might think. Pinning is the result of market makers hedging their portfolios to keep their portfolios delta neural.

This was explained in a book by Adam Warner (a former market marker) called Options Volatility Trading.

When you buy a call, if there is not one sitting on the shelf (i.e., another person willing to sell a call that they own) the market maker must create a call to sell to you. That’s what a market maker does – they “make markets.”

They will take the other side of your call. Thus, you have a long call and they have a short call.

The market maker does not want to have the risk of naked short call. So, they will as hedge their position by taking on a synthetic long call. A synthetic long call is long stock and a long put. (They do that trade on margin, which is the reason risk free interest rate factors into the price of an option. Someone has to pay the price of the margin for the borrowed stock. It goes into the price of the call.)

That leaves them with a position where the risk which cancels out.

Since the market maker has the benefit of doing business on the other side of retail traders, i.e., they buy at the bid and sell at the ask, they can create a risk-free guarantee profit. (To see what I mean, go to your broker’s options risk analyzer and model a short call, long stock, and long put. You will see a flat risk profile that shows a loss. Since the market maker is on the other side of that trade, your loss would be their profit.)

That seems simple enough to understand. But, in reality there are hundreds or thousands of different options that a market maker has in their portfolio. They may not be cancelling one-for-one on each option. They look at their portfolio and pick the strikes that hedge their whole position. The result is a portfolio that is delta neutral around where the stock is trading.

As options expiration approaches, the most important thing for the market maker is to keep their position delta neutral. But, since gamma becomes very high at expiration, just small changes in the stock can make big changes in their portfolio.

As the stock rises, the market maker’s portfolio will become more delta positive. What’s the easiest way to remove delta? (What instrument has the highest delta? Stock.) They sell stock. When large sell orders go to the market, what does the stock price do – rise or fall? It falls.

As the stock falls below their target, their portfolio becomes more delta negative. What’s the best way to add delta to your portfolio? Buy stock, which makes the price do what? Rise.

The market maker isn’t necessarily trying to move the price of the equity. They are just trying to protect themselves. But, the result is the same. The stock price moves to a strike and the stock pins.

So, if you listen to a market maker tell the story, they are just managing their risk. To rest of the world it looks like manipulation.

I guess it’s just a matter of semantics. The fact remains that pinning (or also called pegging) is very real and does occur.

There are a couple of websites that specialize in this. You can visit: http://www.optionistics.com/f/strike-pegger or http://www.optionpain.com/. Both of these sites consider a theory of “maximum pain” – which is the strike where option buyers will experience the greatest losses (or minimum pain for options sellers.) My experience is that the stock doesn’t normally hit the “max pain strike,” but it may move in that direction.

Personally, I have played the “pin the tail on XYZ” game. It can be low cost, high return trade. An example of this might be a $10 wide butterfly on Google (GOOG). If you pick the short strike to be out of the money, about one week before expiration, the trade will cost you around $1.00. (That is a debit trade with a net investment of $100 for a 1 contract butterfly.) The maximum profit is realized if the stock expires at the short strike and would be $9.00 (or $900 for 1 contract.) When I have done this trade, I don’t try to hold the trade all the way to expiration. I have typically, looked to yield a 300% ROI. So, I would place a good-til-cancelled (GTC) order for $3.00. It is a low probability trade. But, has a high ROI. If you place this sort of trade three times and it works once, you’ve broken even.

But it’s more of a gamble than a viable investment strategy. I don’t believe that you can turn this into a reliable way to make profits. But, it can fun to trade.

While you are not going to make a living on this trade, I believe that it is important to be aware of the pinning effect. If you do credit trades (e.g., Iron Condor, Bull Put, or Bear Call) the typical primary exit strategy is to allow the options to expire worthless. You can watch your trade as it approaches expiration, thinking you’re going to expire out-of-the-money. Then in the very last few minutes of trading, the stock makes a drastic move and you find your options become in-the-money. This is another reason I prefer to close short positions early, and not take them all the way to expiration.

Eric Hale

OptionsANIMAL Instructor

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