The Influence of Option Expiration

This was originally published on RealMoney. It is being republished as a bonus for TheStreet.com readers.

As Friday's Aug. 15 option expiration approaches, people always wonder how it will affect price action of both individual stocks and the broader market. One of the top questions is the notion of "pinning," or for prices to be drawn to a particular strike price.

First, I'd say the impact of option expiration is overblown, as it is akin to the tail wagging the dog. That is, it would take large open interest of a near-the-money strike, let's say share equivalent of 25% of the underlying stock's daily average strike, to override the prevailing news or influence price movement.

As far pinning goes, yes, strike prices with large open interest can act like a magnet, but remember, the force can be either attraction or repulsion. Much depends on recent trading patterns. In a low-volatility environment, you might see more gravitational pull or pinning.

In a high-volatility environment, such as the large daily price swings we recently witnessed, there might be the opposite, as traders need to defend positions. So, as a stock moves through one strike, those short options need to hedge and will buy or sell stock accordingly, which will exacerbate the price move and push the stock toward the next strike.

Here is how the dynamics might play out in actual equity options:

Imagine I'm long five $17.50 calls in XYZ. As the stock rises above the strike, I can look to take a profit either by selling the stock in an attempt to lock in a small profit, or by simply closing the position by selling out the calls. In both cases, this creates selling pressure and drives the shares back toward the $17.50 strike price. If I sell out the calls, they are bought by someone else, who now in turn might short shares of XYZ.

This plays out on both the put side and the call side. The larger the open interest at the strike, the greater the magnetic pull. Most of this trading is done by market makers using their long gamma inventory as a way to scalp a few dollars on expiration day. Given that market makers tend to trade from a delta-neutral standpoint, in the absence of other outside forces, it's no surprise a stock's price hugs the at-the-money strike price.

This leads to the misconception that market makers represent some sort of monolithic front that can move not only stock prices toward the strike price, but have an impact on broad market indices. This explanation expiration of pinning action falls under the totem pole of the many conspiracy theories of trading and is just below some of the gold bugs astrological lunar, as in lunacy, theories. While some manipulation might occur in a very thinly traded stock with a small float, those are the exception rather than the rule.

The point is that it depends on how your position is built that defines your needs. And in no case will the physics of market forces be influenced by the few dinghies that MM's can use to catch some sets of waves.

Sure, huge open interest can influence trading, as people need to either defend or liquidate positions. But that does not rear its head until about two days prior to expiration.

Since market makers tend to be short premium but long gamma they don't need or want anything but more volume which allows them to scalp stock against their option position which will drive prices towards the strike price.

Right now the S&P 500 Index is flirting around the 1300 level and depending on how the market closes today might define what type of magnetic force it will exert. I'll try to screen for some individual stocks that have outsized open interest at strikes prices within a 2% of where the underlying shares are trading

But honestly, unless you are a very active trader I don't think this a good use of your time or proper way to trade options.

This was originally published on RealMoney on August 14, 2008. For more information about subscribing to RealMoney, please click here.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback; click here to send him an email.

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