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• Posted by Adam Warner
• on August 24th, 2009

Blue Cat leaves this in a comment.

Adam, I’m confused by this explanation. You talk about call owners whose calls are ITM. Why are they concerned about hedging anything? Are you saying they are shorting stock against their calls as a way to realize their call profits? Why be so circuitous? The options are about to expire anyway. Why not just sell them and take the profits?

Ok, let me differentiate between two sorts of options holders. A passive buyer who simply owns they as investment and a Market Maker/Specialist/Trading Desk sort that actively hedges. As a general rule, a pin is more likely when an active trader owns the bulk of the open interest.

In either case, owners are concerned about hedging because the calls they own are about to go “binary”. They will have 100 delta if the stock closes above strike. In other words, they are now stock. Likewise, they will have zero delta under strike. But let’s say they were modestly in the money heading into expiration day, call it 60 delta, with an open interest of 10,000. If active traders owned all of them, they have already shorted about 600,000 shares of stock against them. But over the course of the day, that leaves them 400,000 more to sell if the stock is above strike.

If it’s a passive holder, they have probably not hedged at all. They can still do nothing, in which case they are now probably going to get long stock. They can also simply sell or roll their calls. Or they can hedge by selling stock against the calls. The first tack is unlikely as they probably own calls instead of stock for a reason. But if they go that route, it will have no effect on a pin.

IF they simply sell the calls (not relevent whether it’s for a profit or not) than they transfer hands to another party, probably a professional trader who will then short stock against them. That does add to pin forces on the margins.

And if they roll? What that means is they sell the expiring calls out and purchase calls in a later month. That’s a pretty common tack and again, it likkely puts the expiring calls in the hands of a professional trader, though it also gives him a bearish side to the trade. So thus that will not cause much of a pin force.

The bottom line of all is that the mere act of “expiration” causes all sorts of players to adjust positions in all sorts of ways. And again, these are just call owners. We’re just edifying as to the why of a pin.

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