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.
Option Expiration and Stock Investors How should stock investors adjust their portfolios and trading habits to account for the expiration-related phenomenon? Pinning to a nearby strike price around option expiration tends to dampen price volatility, so it is not an urgent concern for any but the shortest-term equity traders. One area where pinning might have undesired effects is in the daily performance of pairs trading strategies, e.g. if one leg of a long/short equity pair is particularly prone to pinning around expiration. The effects of gamma-exacerbated price volatility are more serious. In individual equities, when monthly expiration looms, investors can look for option strikes that have a level of open interest that 1) is much higher than other nearby strikes and 2) is worth a meaningful percentage of the value of the stock's average daily volume. Options exposure meeting those qualifications could significantly move the underlying if traders decide to close out positions under pressure. Negative gamma near expiration can also drive the market as a whole. Options on equity indexes like SPX and ETFs like SPDR S&P 500 ETF ( SPY) and PowerShares QQQ Trust ( QQQ) are some of the most actively traded in the world, which means that there is almost always a risk on expiration days that an unexpectedly large move will be made worse by the presence of large out of the money put and call exposure. In recent years, the Federal Reserve has announced surprise interest rate cuts on expiration Fridays in a less than opaque attempt to let the cuts have the maximum possible immediate effect. The best way to accommodate the possibility of expiration-induced price swings is to be ready for more volatility by trading smaller position sizes and setting wider stops. Particularly on an intraday level, a volatile Friday morning is likely to beget a volatile Friday afternoon. Finally, an unexpected consequence of this look into the effects of expiration on stock returns is that not all market action turns out to be as meaningful as we might want it to be. Market participants love to assign causality and meaning to day-to-day stock returns, sometimes linking the same piece of news to up and down subsequent days. The truth is that much market action is either systemic or inscrutable. In the case of a particularly quiet day of trading near options expiration, what looks like a passive market may be in part attributable to pinning. A wild day of trading, conversely, may not be purely about panicked, earnest investors, but also about the rational unwinding and resolving of prior option commitments. At the time of publication, Jared Woodard held positions in SPX, SPY, and QQQ.