Option pinning 101
Option pinning 101

Option pinning 101

by Andy Constan

This is a complex topic that most people use graphs to explain. I am going to keep it simple. Pinning occurs when the activities of those who hedge long options position dynamically tend to force the price of the underlying to the strike price of the option. The most important point is that option must be very large and be near the money and with a short time to expiration for this pinning force to overcome regular trading in the underlying equity. The second important point is that the buyer of the option is dynamically hedging and the seller is doing no renewing. Typically this would happen when an investors sells a call to a market maker.

As an aside this topic should not be confused with the fashionable gamma squeeze discussed by meme stock traders who buy out of the money options. I can comment on that in another thread.

Why does a market maker dynamically hedge and option that they own. Essentially by doing so they can take limited directional risk and capture the realized volatility that occurs hoping that volatility generates enough profit that they pay off the implied volatility they bought. When you are long a call you benefit when the market goes up. To hedge that the exposure you need to sell short the stock. But when the option goes deeper into the money it acts more like the stock. So the hedger sells short more stock. If the stock then falls the hedge covers. The hedger profits from systematically selling high and buying low. However when their selling high and buying low is very very large their own activity tends to dampen the volatility of the underlying equity. This effect happens above and below the strike but is most pronounced when the option is about to expire and at the money.

But that’s not all. As expiry approaches there is other flows that drive the market to the strike. The first is called Charm. It is the change in delta as time goes on. If a call is out of the money modestly a week ahead of expiration the delta still is short the market. As time moves forward the delta falls to zero resulting in buying up to the strike. At or above the strike the delta approaches 100% as time moves to expiry. That results in selling. And both are strong near the strike

Lastly there is vanna. That is the change in delta as the volatility falls. It has the same impact of pushing the stock to the strike but is not as strong currently in the 4430 situation.

Next week I can explain the roll of the JHEQX