Options Slang Explained: 'Pinning the Strike'

Also: A straddle play on Rambus' day of reckoning, and what happens to options in a spinoff.
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OK, we get the message: Cut down on the slang. Options shouldn't be complicated by traderspeak. So don't hesitate to send off an email with a reminder to word explanations in English.

The first jargon alert was prompted by the recent use of the term "pinning the strike." Enough readers wrote in about it that we decided to address it again here. And keep sending your options questions -- and jargon alerts -- with your full name to

optionsforum@thestreet.com.

Jargon-Free Rewrite

Is there any way to rewrite the Heavy Trading in AOL, Dell Leads Tech Options Plays article to explain the technical aspects? There were a lot of fundamental options effects that I just don't understand -- like "pinning." -- Michael Zaiontz Why would market makers want buy and sell the stock just to even out the price? It sounds like the tail wagging the dog. -- Dennis Eckert

Michael and Dennis,

In English, "pinning the strike" happens at expiration for the most part, according to John Brett, executive director of equities at

Warburg Dillon Read

and an options expert.

Essentially, there is a river of stock options being bought and sold in some companies on expiration day to hedge against positions. If a stock has been hovering around a certain price, say 95, and hefty put and call bets have been made at or around that strike price, the activity can be wild. Often, but not always, investors end up buying and selling so much stock to hedge or unwind a position around the strike price that by day's end, the stock has been "pinned" at that level.

Take a stock like

Microsoft

(MSFT) - Get Report

, which could by month's end have a huge but fairly equal open interest in the September 95 puts and calls.

"Assume that today was expiration," says Brett. "I'm long a call, meaning I've bought a September 95 call. The massive unwinding of my position and other people's positions causes an arbitrage around the strike price. It's not that I have an economic interest in having it close at 95; but I've probably shorted the stock against my call because I want to protect myself."

"Say there's 20 minutes to the close of trading," he continues. "If I'm long the call and it's at 95 1/2 I can do two things: I can exercise those calls and buy the stock. Or I can try to sell those calls at a discount in the trading crowd, and in the meantime, just to protect myself, sell the stock short at 95 1/2 myself."

Replicate John's explanation 1,000 or 10,000 times, and there's a lot of tugging going on, especially if there are equal put and call bets. "Pinning the strike doesn't always happen," Brett continues. "But it tends to happen more often than not, especially when there's healthy open interest around a certain strike price."

"In other words, every time the stock goes above or below 95, there's going to be someone buying or selling it to hedge themselves," the trader explains.

Straddling Rambus

It seems to me that Rambus' (RMBS) - Get Report impending "day of reckoning" presents an opportunity for a buy straddle -- purchasing both September 115 calls and September 80 puts, for example. The idea, of course, is that no matter how Intel (INTC) - Get Report leans, it will have an outsized impact on Rambus' share price. What do you think? -- Ari Nadin

Ari,

Before we go further, a straddle is when an investor buys or sells an equal number of puts and calls having the same strike price and expiration date. The trade you are asking about sounds more like a "strangle," which is a put and call at different strikes but the same expiration.

In any case, we decided to go straight to the horse's mouth for the answer, and we rang up Randy Emer, a partner with

Eclipse DPM

and the primary market maker for Rambus options on the

Chicago Board Options Exchange

. In the middle of the trading day, he was able to juggle screaming orders

and

comment on this trade. Emer reminded us that Tuesday, Aug. 31, is D-Day for Rambus, as

TheStreet.com

detailed in a recent

interview with the head of the chip-design concern. That's the day Intel is expected to signal a move either toward, or away from, Rambus' memory-chip designs.

"Any sort of straddle strategy like this is a good one, especially in a worst-case or home-run scenario," Emer yelled over the din. At current prices, it might be cheaper to buy that September 80 put-110 call trade than something like a September 95 straddle trade. The first setup requires you to buy the out-of-the-money 80 put and 110 call, which cost about $2 and $3 ($200 and $300 per 100-option contract), respectively, while the second scenario costs about $8 and $8 per contract, or $16 ($1,600) for the whole trade.

Think of the trade as an airplane: The September 95 straddle is the body and the original 80-110 trade are the wings. "You're putting up much more money -- roughly $1,600 for the guts of this trade, rather than for the wings," says Emer.

Nevertheless, his contention is that the September 95 straddle "likely will be worth something two weeks from now, whereas the trade on the wings

the September 80 and 110 options could collapse if Intel's announcement is a dud."

In other words, if the stock doesn't move wildly in reaction, both the 80 put and the 110 call expire worthless. Also, Emer points out that from his perspective in the trading pit, "there have been as many sellers as buyers of September options. It leads me to believe there might not be as much of an impact on the stock price as people think. It might already be in the stock price," which by the way, has been trading around 96.

Spinoff City

If I trade an option and the company gets bought out, has a spinoff or merges, what happens to the option? I am speaking of expiration dates that are after the activity. Do they exercise on that date and you lose your time value (or keep it if you are short)? In a spinoff, for example, of General Motors (GM) - Get Report and Delphi (DPH) , what happens to the options? Do you get extra options, or do they create options in the spinoff? -- Greg Kimura

Greg,

The CBOE has a terrific Web site with a section under Traders Tools titled

Stock Splits & Mergers. Any investor can visit the site, punch in the stock symbol or company name and find out what their rights and obligations are as a result of a stock split or merger.

TSC Options Forum aims to provide general securities information. Under no circumstances does the information in this column represent a recommendation to buy or sell securities.