Pinning and open interest Max Pain are very different. Pinning is causal. Open interest Max Pain or any type of Max Pain is artificial price movement. Let me explain.
On 12/30/11 Apple (NASDAQ:AAPL) closed $405.00. This was a Friday or weekly options expiration. Why did Apple close exactly at $405? Isn't this manipulation? No, not even in the slightest. Pinning is primarily caused by options closing. I am well aware of delta/gamma hedging. This type of hedging or activity can be disproved as a major contributor to pinning quite easily. I will use one example, a simplified version. You buy 1 $405 call which expires that day (Friday). Apple is $402 at the time. Let's say a Market Maker (MM) sold you this call. Let's also assume they are Delta hedging. In this hypothetical, when you bought your $405 call, the Delta was .10.
As the stock moves towards $405, the Delta will increase. In this exercise, Delta will be 1.00 when Apple reaches $406. If the MM is Delta hedging, they will sell you the $405 call and offset it with a purchase of 10 shares. The stock has moved up to $404. The Delta is now .60 and the MM had to buy and additional 50 shares for a total of 60. Apple has moved to $406. The MM now has 100 shares as the Delta is 1.00. On 12/30/11, there were more than 30,000 $405 calls traded. If Delta increases on the $405 calls, so must the MM increase his purchase of shares. If you start multiplying that figure, it sure doesn't make a case for the stock going from $406 to $405. The stock should continue up, not down.
Now back to "pinning is primarily caused by options closing". Using the same example above. When Apple is $406 the MM holds 100 shares long as the Delta is 1.00. Now you decide to take your profit or loss and close your call out. You sell it back to this MM. You both hold zero option positions, but the MM still has the long 100 shares. They need to sell these as this hedge is no longer required. Multiply this sell of 100 shares and you can see how Apple moves from $406 to $404 very quickly. The opposite is true with puts. If the highest volume is on the $405 puts when Apple is $404, put buyers will want to close their position. The MM will buy 100 shares, covering their short 100 share hedge. This happens all day on either side of $405. This is what causes the stock to pin exactly $405.00.
Here is a visual. There are 3 spikes. The left represents the open interest (OI) for puts, right side is OI for calls and middle is the volume for Friday. (Visual only, not accurate figures.)
Volume is also a major factor in pinning. On 12/30/11 the highest volume was on the $405 strike for both puts and calls - hence the $405.00 close. If the highest volume was on the $400 strike for puts and $405 strike for calls, then the stock would close $403.xx. If the highest volume was on the $410 strike for both puts and calls, then $410 pin would occur.
Open Interest Max Pain:
Max Pain theory is based more on 'unnatural' price movements. Now, there is no doubt that option hedging and closing out positions contributes to this theory. But the largest contributor to Max Pain is artificial stock price moves that benefit option writers which carry no or very little hedge. Max Pain can be seen when there is small net option activity, yet Apple will magically get rejected from the highest call OI or be supported at the highest put OI. Below is my OI graph from 12/30/11. The highest call OI is $410 and the highest put OI is $400. Option writers who are uncovered would benefit if Apple expires somewhere in between.
Below is a chart of Apple for the week of 12/30/11. It is broken out into days. The low for the week was $400.51 and the high was $409.09.
Notice the high was on a Tuesday? In this case option open interest is still increasing. People are opening $410 calls, not closing them. Remember from above, when you open a call, the seller offsets it with buying shares. If everyone is buying calls then buying pressure should keep advancing Apple's stock. It didn't, acting like a brick wall the $410 level was rejected. So we can remove option hedging or closing as a result of this.
We are left with option writers who are unhedged. These are the funds that find 'somehow, someway' to move Apple down and protect the $410 calls they wrote. Notice the stock sold off aggressively $9. But wait, these same people will not benefit if Apple falls below $400. What do you know, 'somehow, someway' the stock found its way higher.
What you witnessed Tuesday -Thursday, is Max Pain my friends. What you witnessed Friday is pinning. Very different.
Pinning can occur on any strike. Open interest Max Pain is what keeps Apple in a tight weekly range, not allowing it to go above or below the highest OI strikes.
Pinning is caused by options closing. It is in no way manipulation. It’s a part of the market option inventors didn't plan for. Open interest Max Pain is not a side effect. It is caused by option writers who are fully aware of their profit and loss levels. These levels are protected as it is beneficial to them and more importantly, real money is on the line.
(My OI/Max Pain uses the basis of the original Max Pain theory. I have altered it so it can be used for trading.)
Disclosure: I am long AAPL.
Additional disclosure: Short puts, short calls, short put spreads.