Pinning and Maximum Pain in the Options Market

A reader asked me to comment on the subjects of pinning and max pain in the option market. Although it may sound like it, these are not terms from professional wrestling. They are option-related terms that describe the behavior, or alleged behavior, of stock prices on option expiration day.

Pinning is the tendency of a stock to close on option expiration day at a price that is very close to an option strike price. For example, if a stock has options with exercise prices (strike prices) at $100, $102.50 and $105, and there are many option contracts outstanding, the stock is far more likely to close within a few pennies of one of those prices than not. In other words, the theory goes, a closing price of $99.90 – $100.10, or $102.40 – $102.60, or $104.90 – $105.10 is more likely than prices that are farther away from the strikes. If the stock does close very close to a strike price, we say that the stock price has been pinned to the strike.

There is a related idea called the point of maximum pain. The theory here is that stocks tend to close on option expiration day not only at a strike price, but at that particular strike price at which the total value of all outstanding options, including both puts and calls, is at its minimum. Thus the owners of options in the aggregate suffer the largest possible loss, and the writers of options as a group enjoy the highest possible profit.

Some people attribute this behavior of stocks to manipulation by option market makers to increase their profits. Others believe that it results from normal and legitimate hedging transactions, with no evil intent. Still others don’t believe that these are real phenomena at all, but just crackpot theories.

So which is it? And is there any way for us to take advantage of these phenomena, if they exist?

It turns out that there is a fair amount of academic literature on these subjects. Some scholarly articles were written between 2003 and 2009 by credible researchers in the field:

• Avelleneda, M. & Lipkin, M. (2003). A Market-Induced Mechanism for Stock Pinning. New York University Courant Institute Working Paper.

• Xiaoyanni, S., Pearson, N., & Poteshman, A. (2005). Stock price clustering on option expiration dates. Journal of Financial Economics, 78(1)

• Pearson, N. D., Poteshman, A. M., & White, J. (2009). Does option trading have a pervasive impact on underlying stock prices? Unpublished manuscript, University of Illinois, Urban-Champaign. (Cited by R. Pendola in Seeking Alpha, May 2011).

In summary, I interpret the findings as follows:

• Pinning does in fact happen. The expiration-day closing price of stocks with options really does tend to be near option strike prices (within $.125) with far more frequency than pure chance would explain, and the difference is statistically significant.

• This is bolstered by the fact that stocks with options are pinned and stocks without options are not; stocks that had no options were not pinned, then began to be pinned when options on them began to trade. Other stocks that had options and were pinned, stopped being pinned when options on them stopped being traded.

• Pinning does not happen to every optionable stock on every expiration date, but it does happen significantly more often than it should occur by chance.

• Pinning happens more frequently in cases where the stock was already near a strike price as of the close on the day before expiration; it is less common for a stock to be drawn to a strike price that it was not already near.

• Pinning actually happens more often when the net position of all the option market makers for a stock, as a group, is long options as opposed to short options. This is the opposite of what would be expected if option market makers were intentionally manipulating stock prices to make them expire at the point of maximum pain.

• The actions of delta-neutral traders (those who hedge option trades to minimize the impact on them of stock price movement, which includes both market makers and other large traders) would cause stock prices to be driven toward a strike price as the hedges are adjusted leading up to expiration in any case. No collusion or intentional manipulation is necessary to account for this.

• In any event, the influence of option traders of all kinds can be swamped on any one expiration day, if an event occurs that is market-moving for the stock to a greater degree than their combined actions, whether those actions were concerted or not.

• Intentional manipulation is not ruled out and probably does occur. But it is most likely a small factor compared to the normal hedge adjustments of market makers and other delta-neutral traders.

In the end, the maximum pain idea is unlikely to be a reliable source of profits. Pinning shows more promise, since it is at least a real thing. But it is not a tractor beam that draws stock prices inexorably to a strike from far away. Since it happens more often when the stock is already in the area of a strike, it can be more of a force for keeping a stock from moving far, than for making it move very far. In my opinion, it is not worth betting the farm on either maximum pain or pinning.

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