Effects of Stock Pinning on Option Prices
Stock pinning happens when a stock price stays at or near an option strike price on the day the option is due to expire. Stock market experts have noticed that stocks with heavily traded options close near the option price on the third Friday of the month, which is when most stock options are set to expire. These trades act as a tug of war on options prices. Stockbrokers and options traders use this information to make profitable trades.
Stock options give the buyer the chance to buy or sell a stock at a specified price, called the "strike price," between the purchase date and a future specified date. An option to buy a stock is called a "call" option, while the option to sell a stock is known as a "put" option. Options give buyers and sellers the choice to purchase or sell their stock at the strike price, but the option holder is under no obligation to complete the transaction at the strike price.
Stock pinning occurs when traders on both sides of the options table attempt to move the stock price in their favor. The option holders who benefit from higher stock prices will buy more stock to raise that price before the option expiration date, while those who would profit from a lower closing price will sell shares to force the price down. This tug of war leads to the price being "pinned" at or near the strike price.
Black and Scholes Model
In 1973, financial experts Fisher Black, Robert Merton and Myron Scholes developed a mathematical model for options trading. The model contains variables such as the price variation of the option, the time value of money, the option's strike price and the time left until the option's expiration date. The model also carries some restrictive assumptions, such as an efficient market, a constant risk-free rate of return and the stock paying no dividends between the purchase date and the option expiration date.
Risks of Pinning
Stock pinning depends on both sides of the option trading at or near the same volume. The risks of pinning occur when one side or the other abandons its position and allows the other side to make a higher number of trades. This forceful action in one direction can drive the prices up or down at a high velocity and disrupt the stock's value. Option holders on the wrong side can experience serious losses from such a sudden shift.
Living in Houston, Gerald Hanks has been a writer since 2008. He has contributed to several special-interest national publications. Before starting his writing career, Gerald was a web programmer and database developer for 12 years.