Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Option Open Interest And Pinning

Options are powerful derivatives than can affect the price action of an underlying security. These instruments represent -- and sometimes settle into -- actual shares of a stock, thus changing the current supply demand dynamic. The action of pinning a stock to a strike price refers to the underlying asset's price closing near the closest strike price. This happens as a result of large open interest outstanding at that strike price at the time of expiration. Open interest is a vital concept that investors must understand before trading stock options.

Open interest is defined as the number of contracts that have been traded, but have not settled. An option settling refers to the action of making an offsetting trade. An offsetting trade can include exercising or assignment of the contract. The action of being exercised or assigned is when actual shares of the underlying security are bought or sold at the contracted strike price.

Pinning normally takes place at a strike that has large amounts of open interest and is near the current price. These traders and market makers, who waited until expiration day to take care of their position, are on the cusp of a being 'in' or 'out' of the money. It is this very uncertainty that makes traders adjust or hedge positions. Should an option be 'in the money' by one penny or more,most brokers automatically exercises the aforementioned option. Options that are exercised result in long or short shares the next day of trade. To neutralize the risk of ending up 'in the money' hedgers and speculators square up their positions with stock, hence pinning the stock as they make these adjustments.

Most retail investors tend to be on the long side of an options contract, because of margin requirements demanded by brokers for the opposite side. Long puts and calls limit risk to the premium paid, but if the contract is held post expiration more capital is needed for assignment or exercise. In order to prevent assignment, options trades should be taken care of before the close of expiration Friday. In the case of a pin, an option will be borderline 'in' or 'out' of the money. Staying long or short the contract may pick up a few pennies, but if an investor doesn't exit the contract, assignment or exercise becomes a reality and then overnight gap risk is being taken.

According to the Chicago Board Options Exchange, about 10 percent of options are exercised, actual shares being transacted after expiration, while the main chunk of positions, 55 to 60 percent of option positions, are closed prior to expiration. Finally, about 30 to 35 percent of options expire 'out of the money.'