Often, particularly in the comments' section of articles at sites such as Seeking Alpha and on stock message boards, investors refer to the options market as "rigged." Many people believe that somebody (market makers and hedge fund managers often get the blame), somewhere (usually the broad location "Wall Street") pulls every ounce of force they have out of their back pocket, causing popular stocks, such as Apple (NASDAQ:AAPL) and Citigroup (NYSE:C), to close out options expiration day at a particular price. This price action, called "pinning," as the theory goes, serves as a means to the manipulator's end of protecting thher own positions and generating profits.
Like many wise individuals, I often fall victim to the notion that this seemingly mysterious price movement has everything to do with manipulation. Thankfully, logic and my growing understanding of options usually wins out. To bring us all back to reality, I called on WhatTrading.com Senior Options Strategist and Seeking Alpha contributor Frederic Ruffy to answer a few questions.
Rocco Pendola: In the options market, what does "pinning" or "pinning" the strike refer to?
Frederic Ruffy: Pinning happens around the options expiration when the price of the underlying asset (stock, index, futures, ETF) moves toward the strike price of an options contract. It can cause a headache for an options trader because it becomes uncertain whether or not the contract will expire in-the-money, at-the-money, or out-of-the-money. ATM and OTM options expire worthless. However, if the contract is ITM at expiration, exercise/assignment of the contract comes into play. The uncertainty stemming from pinning is sometimes called Pin Risk.
RP: Do you believe this happens frequently? For instance, many people claim that Apple was pinned to $330 and Goldman Sachs (NYSE:GS) to $160 a couple of weeks ago.
FR: Yes, it happens all the time. It's impossible to predict which stocks will see pinning beforehand, but around the expirations, you will often see heavy trading in certain options contracts that are at-the-money and set to expire.
RP: Is pinning all about manipulation?
FR: To my knowledge, this is not a deliberate attempt to manipulate prices around the expiration, but more related to the mechanics of the options market. The buying and selling, unwinding of hedges, tends to result in pinning. There is a similar concept known as the theory of maximum pain. According to max pain, the price of the underlying stock tends to gravitate toward the strike price where the greatest number of puts and calls expire worthless. It's the point that inflicts the most pain to option holders (the most gain for option writers). I don't think there is anything illegal going on to manipulate prices around the expirations. Of course, I could be wrong, but I'm not sure that it would be possible - especially in a large actively traded name like AAPL or Google (NASDAQ:GOOG).
Since we have Fred's time, I decided to ask a couple of general questions.
RP: What is the biggest win you remember seeing in your experience as an option trader (not necessarily your own)?
FR: That's a tough one. I wrote about an interesting spread in Apple last week. It was a 345 - 350 call spread in the Weeklys for 10 cents in AAPL. Shares finished the week at $351,54 and the spread was worth $1.50, a gain of 1,400 percent in two days (see Thursday's options recap).
RP: Biggest loss?
FR: Can't think of it on the top of my head. It's probably selling index puts before a market debacle. The losses to options buying is limited to the debit paid. The biggest losses happen from writing uncovered options, which is why those strategies require more margin.
RP: Your favorite and most profitable strategy to employ?
FR: Biggest percentage gains come from spreads like butterflys and vertical call spreads (buy a call and sell a higher strike call). The most consistent trade is the simple buy-write (buying stock, selling calls).
RP: Is there anything else you would like to add?
FR: Options trading takes a little time to understand and learn. Many investors use puts and calls to speculate and try to hit home runs, rather than singles and doubles. The best approach is to learn a mix of strategies and use options in combination with other long-term strategies. Developing long-term goals and a trading plan is the first step. The next is to understand the risk-rewards of various trading strategies. Then, use strategies that have risk and rewards that are consistent with longer-term goals like generating additional incomes, using puts to hedge risk, buying calls and spreads to participate in moves in quality stocks, and using more advanced strategies to generate profits, even when the market is simply moving sideways.
Disclosure: I am long AAPL.