Rocco Pendola: Please define pinning and the theory of maximum pain.
Neil Pearson: "Pinning" and "maximum pain" are closely related. Pinning refers to the phenomenon that on option expiration Fridays the prices of optionable stocks tend to close on or very near to option strike prices. This is not to say that this Friday AAPL will necessarily close on or near to an option strike price, but rather that AAPL is more likely to close on or near to an option strike price on Friday than on any other day of the week.
The theory of maximum pain goes further, saying that the stock price will tend to move toward the price where the total value of options contracts, both puts and calls together, is the lowest. This theory thus identifies the specific option strike price that will tend to attract the stock price. If the stock price closes at the strike that minimizes the total value of options contracts, this minimizes the value received by buyers and paid by option sellers when the options expire. Because this benefits option writers, some market participants claim that the stock price movement is caused by option writers manipulating the stock price to create profits for themselves and losses to option buyers.Note: In this example, Pearson used a hypothetical during May 2011 to illustrate the concepts we discussed.
NP: Let's use AAPL as an example. Friday, AAPL's closing price was near $340. Further, let's suppose that there is a large trader or group of traders who follow a hedging strategy that requires them to sell aggressively if AAPL rises above $340, and buy aggressively if AAPL falls below $340. If this is the case, their trading will have a tendency to "pin" AAPL at or near $340. It is only a tendency, because during the week there might be some event, either a news announcement or trading by some other investors, that dwarfs the effect of the hedging strategy and moves AAPL away from $340.
In the explanation above, AAPL pinning at $340 is an incidental byproduct of the hedging strategy. (Emphasis Added)
NP: I think most pinning is caused by hedge rebalancing, i.e. it is an incidental byproduct of perfectly legal hedging activities. You might wonder, whose hedging? What large trader or traders could possibly be following hedging strategies that cause stock prices to pin? The answer is that delta-hedging trades executed by options market makers can have this effect.
NP: You shouldn't think about cooperation or a conspiracy. You should think that traders often have similar trade ideas, and as a result sometimes end up with similar positions. Then each independently tries to "protect" his or her written options position by trading in the underlying stock so as to prevent the written options position from expiring in the money.
In thinking about whether it is plausible that stock trades executed by options traders have material impacts on the prices of the underlying stocks, you should keep in mind that the only other explanation for pinning is that (hedging) stock trades executed by option traders cause pinning. That is, the only two plausible explanations for pinning involve stock trades executed by options traders. The two explanations differ only in the motivations for the stock trades.Follow @rocco_thestreet --Written by Rocco Pendola in Santa Monica, Calif.