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How Options Expiration Affects Stock Prices

NEW YORK ( RealMoney) -- Even if you have never traded a put or call, it is important to understand how options expiration can affect stock prices. Trading activity in options can have a direct and measurable effect on stock prices, especially on the last trading day before expiration. Let's look at two ways that options expiration can influence the overall market as well as specific equities, and then consider how investors should deal with these tendencies.

Pin Risk

"Pinning" refers to the price of an underlying stock trading closer to an actively-traded option strike price than it would absent the options activity. Imagine that today is the last trading day before expiration, and that an investor has sold 100 Google (GOOG) put options struck at 615, meaning that she has the obligation to buy 10,000 GOOG shares from a put owner who decides to exercise their option. If GOOG closes above $615, the put options will expire worthless, allowing the trader to keep the premium received from the sale. However, if GOOG closes at $614.95, the options will likely be automatically exercised, leaving the investor long 10,000 shares at the start of trading on Monday.

Many investors don't wish to run the risk of the stock gapping down at the Monday open, so they enter stock positions designed to keep the stock price away from the short strike of their options -- this is particularly true for investors and firms with large option positions relative to the trading volume in a stock. In this example, if GOOG moves down from $615.50 to $614.90 during Friday trading, our investor might buy GOOG shares at the current market price in enough size to apply upward pressure to the stock price.

Imagine, then, that the stock drifts back up to $615.20. Our trader no longer needs the just-purchased shares, since the price has moved above her strike price, so she might sell some or all of the stock position; note also that option traders who have sold short the 615 calls will have the same incentive now to sell short GOOG stock in an effort to get the stock back under the $615 level. This back-and-forth action driven by the exposure of option traders causes stocks to remain close or be "pinned" to strike prices with high open interest. The effects of pin risk on stock returns have been evaluated in several academic papers. One study from 2004 found that the returns of stocks with listed options are affected by pin clustering, on average, by 0.65%, for a total market capitalization shift of $9 billion.

Gamma Explosion

Sometimes, however, the other factors influencing price movement will easily overwhelm any nascent pinning pressure. Imagine now that on expiration Friday, GOOG shares open down 2% at $605. Traders who might otherwise have thought about trying to defend a short option position -- causing the stock to move back up to $615 -- know that the value of their option position is worth less than the capital it would take to influence the stock to such a dramatic extent. Instead, it will make more sense for them to buy back the short put options. This creates more selling pressure in the stock, since the market makers who offer those 615 puts to our traders will hedge their own new exposure by selling short equity shares.

Because the time to expiration is so short, the gamma of the 615 options and any other near-the-money options will be very high. Gamma is the risk variable that measures how much an option's stock price sensitivity (its delta) will change for each point move in the underlying. High gamma means that option hedgers will need to buy and sell more shares than they otherwise would if the options in question had many weeks or months to expiration. Since the hedging activity in this scenario is in the same direction as the short-term price trend, the high option gamma at expiration can exacerbate price volatility. Think of gamma as lighter fuel. It will not cause a fire by itself, but given the spark of a sizable move in the stock, what might be a slow burn on an ordinary day can turn, on expiration Friday, into a major conflagration.

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