Apple and the dynamics of 'pinning'
Chris McKhann | email@example.com
AAPL plunged more than $22 yesterday to its lowest close since May, continuing its slide since hitting all-times highs above $700 in September. The stock entered bear-market territory when it broken below $564 in the morning, marking a 20 percent decline from that peak.
Many owners of the stock are looking for a reason or, perhaps, a scapegoat (stocks do go down after all, even those we love and own). One suspected culprit is something known as "option pinning," which we will explain in a moment.
First, let's look at the simplified dynamics of an option trade. When you buy or sell an option, the other side of the trade is almost always a market maker. You may be looking to play a direction, but they are not and will quickly get "delta-neutral."
Remember that the delta of an option tells you how much the option's price will change for a $1 change in the underlying stock. So if you buy an at-the-money call, the delta will be roughly 0.50 and the option will gain $0.50 if AAPL gains $1.
If you buy 10 of those calls, you will have a total delta of 500. The market maker will sell you those calls and become short the 500 deltas, so he or she will then buy 500 shares to get neutral.
That delta will change as the price of AAPL does, and it needs to be re-hedged on a regular basis. The gamma of options, or the rate at which that delta changes, increases as you approach expiration--and, therefore, so does the necessity of hedging. (See our Education section)
This is where "pinning" comes in. Stocks often move toward the nearest strike with most open interest at expiration as traders try to buy or sell equities to push them toward strike prices that will leave their options in the money. That in turn forces market makers to adjust their hedges accordingly.
This has always been true, but it now occurs every Friday with the introduction of weekly options, instead of just once a month. And that increased frequency has made pinning more noticeable, leading to more claims of manipulation.
It actually is just a natural part of market dynamics: Market makers serve an important function. The fact that they are hedging themselves should be understood and not blamed.
Is there manipulation in the stock market? Well, we all know that insider trading, high-frequency algorithms, and other issues work against retailer traders. But they are a fact of life that we must understand to participate effectively in the markets, if only to know when to get out of the way.
I would argue that traders would be better served reading up on behavioral economics than looking for a scapegoat. Reading up on "confirmation bias" and the "endowment effect" would be a good starting point for those that may be a bit too attached to their stocks.
(A version of this article appeared in optionMONSTER's Options Academy newsletter of Nov. 7.)