Hanging in the Balance Ahead of Expiration

Roiling and Rolling

Watch for large institutions that had established sizable long protective put positions. As I noted in this recent article on option volume, investors have been buying put protection even as stocks rallied over the last two weeks, seemingly in response to the market's failure to take out the July highs by reducing risk.

Some possible adjustments we could see this time include rolling into the October contracts or simply unwinding existing positions by selling out long holdings and their related hedges. The hedges most likely take two forms: covered calls, in which call options are sold short against the underlying security, or married puts, in which puts are purchased as insurance against the long holdings. In either case, the unwinding of positions would create moderate downward bias and tend to put pressure on option premiums, as the desire to reduce exposure drives prices toward a short-term price equilibrium.

The Pinning Dynamic

The dynamics that can make stocks gravitate toward strike prices, creating support and resistance levels, or the phenomenon known as "pinning," work as follows. Imagine I bought 500 shares of XYZ stock at $16 and I'm short five $17.50 calls. The stock is currently trading at $16.50. For now, I don't need to do anything except hope the XYZ shares rally to $17.50.

Assuming the stock does rise, I could close the position by selling the stock (which creates downward pressure) and buying to cover my short calls. The calls I buy are sold by someone else, who now in turn is short the XYZ calls. They might in turn buy shares of XYZ to offset their short calls (creating upward pressure). The result is to drive the underlying shares of XYZ toward the $17.50 strike.

If the stock goes through $17.50, the people who are long calls at that strike will start selling stock against the calls. Again, that pressures the stock back down toward the $17.50 strike. In issues with large open interest, this battle plays out on both the put side and the call side. While it's hard to make predictions, it's a good idea to be aware of which strikes have the largest open interest, because they can act as magnets.

Pinning Candidates

Here are some stocks that are trading near strikes that still have a high level of September option open interest. Valero(VLO Quote) is currently trading around $111 per share, and the $110 strike has 12,000 calls and 9,000 put contracts still open. After getting slammed Wednesday Best Buy(BBY Quote) might find some support at the $45 level, as there are over 11,000 puts still open but just 3,000 call contracts at the $45 strike. Dell(DELL Quote) always seems to pop as a pin candidate; this time it's the $35 strike, which has 31,000 calls and 29,000 puts open, that could keep the stock hovering at the current price.