Know Your Max Pain Level When it Comes to Options Expiration

NEW YORK (TheStreet) -- Investopedia defines "max pain" as the point at which options expire worthless. The term max pain stems from the Maximum Pain theory, which states that most traders who buy and hold options contracts until expiration will lose money.

According to the theory, this is due to the tendency for the price of a underlying stock to gravitate towards its "maximum pain strike price" -- the price where the greatest dollar value of those options will expire worthless.

I take a little bit of a different approach. Instead of looking for a "pin" point where the greatest number of options expire worthless based on the total dollar value of the options, I find it more helpful to look for a pin where the greatest number of options themselves expire worthless.

Here is an example taken from the April 19 expiration of Twitter (TWTR).

Here is a look at what the TWTR open interest looked like on April 19, the last day of the week to trade the options (note: typically the last day to trade these options is Friday, but markets were closed on Good Friday). You can see that the $45 strike has even more open option positions that could expire worthless. 

TWTR closed that day at $45.01.

How Did That Happen?: Many people think this pinning effect is due to manipulation. That theory is definitely up for debate. I imagine most market makers who are controlling large amounts of stock do have a vested interest in keeping as much premium as they can without having to give up anything in return.

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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