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Know Your Max Pain Level When it Comes to Options Expiration

Stocks in this article: TWTR

However, I believe that most of the time pinning is actually due to the market mechanics of buying and selling options. When calls or puts are purchased, there has to be a seller. Most of the time the seller is likely a market maker. Selling those options carries risk to the market maker and in order to hedge that risk they either sell short or buy the stock outright in order to maintain a delta-neutral position.

To put it another way, market makers will adjust their position of the underlying stock they are selling an option for in order to have zero risk no matter which way the stock goes. As the stock fluctuates in price the market maker will continue to sell short or buy more stock to remain neutral. As expiration approaches and options begin closing out in higher frequency the market makers' rebalancing (buying and selling of the stock) pressures the stock to a certain price point or "pins" the stock.

The higher the open interest on a stock, the larger the volume of stock the market maker hedges with and the greater odds of pressure being put on the stock on expiration day. Hence, the higher-beta, more-liquid momentum stocks are more prone to pin on expiration day. The most frequent type of pinning you will see is a stock closing where the most amount of options expire worthless (as opposed to where the greatest dollar amount expires worthless as mentioned above).

How You Can Benefit: Looking at the open interest throughout the week, especially on Friday morning, can help you determine where a stock might pin. If you know where a stock has odds of pinning you can use that to make winning trades.

Using the above example, when TWTR popped to $46.55 the first half hour of Friday morning you could have purchased TWTR puts, sold TWTR calls or shorted TWTR stock under the presumption that it would close near $45 as it did. 

It's true that the calls and puts of a stock that trade on expiration day can shift the open interest and thus, anticipating where it will pin has its limitations. Stocks don't always pin and often other factors will play a larger role in where a stock closes on expiration day. These factors include earnings releases, news events, large volume based on accumulation or distribution of a stock, and the overall market conditions. However, after over two years of following the open interest on high-momentum stocks I have seen this type of pinning more times than not. 

To learn more about options pinning, please visit the education section of my Web site. 

At the time of publication, the author held no positions in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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