A: Great question. As many may have seen/heard, often times stocks have a tendency to "pin" to an option strike price on expiration, meaning the stock gravitates to a nearby strike as the close of expiration day trading approaches. This "pin" phenomenon arises from hedging pressures, which can create increased demand for the underlying stock below the strike price and increased supply above the strike, as traders and market makers buy or sell stock to offset expiring option positions. These pressures push the stock toward the strike price as the close of expiration draws nearer.

To explain further, first consider that if an option expires in-the-money, it will be the equivalent of either owning 100 shares of the underlying stock (in the case of a call option) or being short 100 shares of the underlying stock (in the case of a put option). If the option expires out-of-money, it is worthless and equivalent to having no position in the underlying stock. When a stock is near a strike price with significant open interest (a large number of open options contracts), the market makers with large inventories of contracts at that particular strike are faced with the problem of hedging an uncertain position that can quickly change from being long/short 100 shares of stock to long/short 0 shares of stock, depending on whether the underlying stock closes above or below the strike price. Depending on the dynamics of the open interest at the strike (whether there is concentrated long/short positions on the call or put side), this can lead to heavy selling above the strike and buying below the strike, which can in turn "pin" the stock to the strike.

Since this can be a confusing topic when trying to conceptualize the different scenarios, let's walk through a hypothetical example. Let's consider Aflac (AFL) which closed at 45.01 on June expiration (6/17). Pretend that as a market maker you owned 1000 June 45 call options. With June expiration approaching, you know that a close above $45 will leave you long 100,000 shares of stock (100 shares per options contract), while a close below $45 will leave you with no position in the stock -- two drastically different positions. As a market maker, you don't want any exposure to the underlying stock, so you need to hedge the position accordingly. This means that as AFL moves above $45, you'll be selling stock to offset the chance of being long at expiration, and below $45, you're buying it back. A similar situation would exist if you were long 1000 puts, as you'd be short 100,000 shares below the strike, and flat above the strike creating the same type of hedging situation. A less certain situation exists with a short options position, as it is unclear what portion of the short contracts would be exercised when the stock is near the strike (whereas you control the exercise of the long options position).

Hopefully the example above demonstrates the type of hedging pressures that arise around expiration. When there is a large open interest and/or large inventory concentrations, these pressures may be exerted by many participants, which can push the stock closer and closer to the strike as the close of expiration day trading approaches.

Chris Borgmeyer, CFA
Director of Live Analysis