Pinning and max-pain theory

[LeSolist 2]

Kim,

 

Do you sometime rely on the "option pain" to get a "gestimate" of the underlying price at expiry to structure your trades?  (In other words, is this metric reliable?)

[Kim 7,513]

I assume you are talking about a theory that the stock will be trading at the strike of the highest OI?

 

This might be true for many stocks, but when earnings are involved, I believe the rules are different. The stock price is impacted more by earnings and it's more difficult to manipulate.

[dbh21 62]

This would be worthy of a separate discussion, at least I would love to hear thoughts. My understanding is that there is little validation to the max-pain theory, but I don't think I've read any studies trying to answer that.

[Marco 221]

This would be worthy of a separate discussion, at least I would love to hear thoughts. My understanding is that there is little validation to the max-pain theory, but I don't think I've read any studies trying to answer that.

there are good arguments for why it should work. Basically many professional market participants trade options not as a directional strategy (buy calls when you are bullish, puts when you are bearish etc) but trade the gamma of the option. That means if they are long gamma (i.e. long options) they will sell stocks to rebalance their delta when the stock price goes up and buy stocks when it goes down. At expiry the gamma (which is the change in delta over stock price change) is extreme as the delta goes from 1 to 0 if the stock price crosses the strike price. So said gamma traders will sell large amounts of stock if the share price goes above the strike price and buy large amount of shares if it drops below. As a result they 'pin' the share at the strike price if the open interest is large enough.

 

Now the caveats why this often doesn't work: For every long option position there is someone else with a short position - so the question is how the open interest is distributed between 'gamma hedgers' and naked option positions (investors who hold option positions without hedging/rebalancing their delta). So if a large institutional player (say a mutual fund) that doesn't rebalance delta sold a chunk of options to a liquidity provider (bank, market maker) than the gamma hedgers are long and there is no offsetting other side (on the stock supply/demand). If the position is between gamma hedgers then they neutralise each other buying/selling shares for their delta rebalance and the effect is MUCH smaller. I've traded options as a 'liquidity provider' at a bank for many years and went trough many expiries so that was a big topic to look at. I would say more often than not shares DO pin on large open interests but there are still many occasions where they don't (I would say the ratio is something like 55/45 - maybe a touch higher) and I found it hard to base a reliable trading strategy around that   

[dbh21 62]

Good post.

 

I've talked to former market makers and they stated the max-pain theory is false. But maybe they are not intentionally moving the market (as many people believe they do), but doing so for the reasons you described (almost unconsciously). They also stated that pinning is usually due to MM's gamma-scalping on expiration day.

[Yowster 8,046]

I read a book a few months ago that covered pinning as one of the topics - "Trading Options at Expiration" by Jeff Augen.  The book goes into a lot of detail on option pricing dynamics and behavior during the last couple of days before expiration covering things like IV collapse, theta decay and pinning.  The book had trade scenarios that are typically ratio trades with naked legs that don't really fit SO, but the discussions on option pricing dynamics during the last days of an option's life are very interesting and good to know.

[PaulCao 51]

Hi Marco, 

 

Thanks for the detailed explanation especially with the hedgers and delta-neutral speculators. This also makes sense I think for why SPY and SPX option series, option premium is usually more expensive on the put side vs. call side because there is more demand by mutual funds to hedge the downside of their portfolio than directional speculators and hedge funds for the upside of the market, 

 

Best,

PC

[bam1960 53]

Great posts guys I appreciate your willingness to share your insights of how the markets work.

 

Thanks

 

Bret

[Kim 7,513]

I read a book a few months ago that covered pinning as one of the topics - "Trading Options at Expiration" by Jeff Augen.  The book goes into a lot of detail on option pricing dynamics and behavior during the last couple of days before expiration covering things like IV collapse, theta decay and pinning.  The book had trade scenarios that are typically ratio trades with naked legs that don't really fit SO, but the discussions on option pricing dynamics during the last days of an option's life are very interesting and good to know.

I would highly recommend most of Jeff's books. Of course a lot has changed since some of them have been published. I had some discussions with Jeff, and he was the first to admit to me that some of his ideas are now outdated. But overall, this is an excellent reading.

[4tach 15]

On 7/24/2014 at 3:11 PM, Yowster said:

I read a book a few months ago that covered pinning as one of the topics - "Trading Options at Expiration" by Jeff Augen.  The book goes into a lot of detail on option pricing dynamics and behavior during the last couple of days before expiration covering things like IV collapse, theta decay and pinning.  The book had trade scenarios that are typically ratio trades with naked legs that don't really fit SO, but the discussions on option pricing dynamics during the last days of an option's life are very interesting and good to know.

@Yowster   Do you recall much of the Augen book Trading Options at Expiration? I am a newish options trader and new to SO [Newbie] but I got into reading this short book and then this topic so that I how I came to this question.

[Yowster 8,046]

6 hours ago, 4tach said:

@Yowster   Do you recall much of the Augen book Trading Options at Expiration? I am a newish options trader and new to SO [Newbie] but I got into reading this short book and then this topic so that I how I came to this question.

@4tachI don't recall specific trade details, only that a lot of them were ratio trades where you are short and long different number of contracts.  The other interesting part was the options pricing dynamics and the last few days prior to expiration.

[4tach 15]

7 hours ago, Yowster said:

@4tachI don't recall specific trade details, only that a lot of them were ratio trades where you are short and long different number of contracts.  The other interesting part was the options pricing dynamics and the last few days prior to expiration.

@Yowster   Yes that is what I am seeing:  ratio trades (maybe a call ratio spread (one call ITM and two-three short calls ATM)) and a 10am long strangle and a late day short straddle. Also, as you say, he gets pretty far into the  options pricing dynamics and more specifically into the almost hour-by-hour Friday expiration behavior. I recognize that a common criticism is that Augen is dated and not pertinent to today's market but I continue to wonder. Augen seems to have done a lot a data munching and has a couple of biases that he cites as deeply ingrained in the trading system: especially his comments about the Friday behavior that he calls patterns. My curiosity is driven by his almost law-like observations that I think he contends go well beyond his samples that he presents. My interest is centered entirely on his Friday expiration discussions in which he points to advantages that private individual traders possess  in the closing hours and in the morning hours too by learning to identify two or three fairly simple patternings in the underlying. Do you have time and/or access to the book for any further banter about this point-of-view?

[Yowster 8,046]

12 hours ago, 4tach said:

@Yowster   Yes that is what I am seeing:  ratio trades (maybe a call ratio spread (one call ITM and two-three short calls ATM)) and a 10am long strangle and a late day short straddle. Also, as you say, he gets pretty far into the  options pricing dynamics and more specifically into the almost hour-by-hour Friday expiration behavior. I recognize that a common criticism is that Augen is dated and not pertinent to today's market but I continue to wonder. Augen seems to have done a lot a data munching and has a couple of biases that he cites as deeply ingrained in the trading system: especially his comments about the Friday behavior that he calls patterns. My curiosity is driven by his almost law-like observations that I think he contends go well beyond his samples that he presents. My interest is centered entirely on his Friday expiration discussions in which he points to advantages that private individual traders possess  in the closing hours and in the morning hours too by learning to identify two or three fairly simple patternings in the underlying. Do you have time and/or access to the book for any further banter about this point-of-view?

@4tachYes, I still have the book but haven't looked at it in quite a while.  You can use the "Messages" feature of the SO website to send me a message to discuss anything related to this.   At the time I read the book, I remember doing some paper trading but never did any live trades using any of the trade examples.  Couple of reasons why:

• Most of the trade ideas are either totally short positions or ratio trades that are short more legs than are long.  While mathematically they make sense, in practice they can require large margin, so in my paper trading I recall adding more long legs farther OTM to balance the shorts and longs and make the trade margin friendly - this obviously changes the trade dynamics somewhat.
• I try to avoid opening and closing trades on the same day to avoid the day trading tax classification and what that entails, and obviously some of the trade ideas in the book require day trading.