Option Pinning

Option pinning is a phenomenon in the options market where the price of an underlying asset tends to gravitate toward the strike price of a large, near-the-money option with a short time to expiration.

This process occurs due to the dynamic hedging activities of market participants, particularly market makers.

In this article, we’ll look at the concept of option pinning, its driving factors, and the significance of charm and vanna (second-order Greeks) in this process.

Key Takeaways – Option Pinning

• Option pinning is a phenomenon where the price of an underlying asset goes in the direction of the strike price of a large, near-the-money option with a short time to expiration.
• It’s driven by the dynamic hedging activities of market participants, particularly market makers.
• Market makers play an important role in option pinning by dynamically hedging their options positions to curtail directional market risk and capture the volatility risk premium (differential between implied and realized volatility).
• Their activities can dampen the volatility of the underlying equity, especially when the option is about to expire and is at-the-money.
• Charm and vanna, which are second-order Greeks, have a significant influence on option pinning.
• Charm measures the change in delta with respect to time passing, while vanna measures the change in delta with respect to changes in volatility.
• Changes in charm and vanna can lead to buying or selling pressure from market makers, contributing to the option pinning effect as the expiration date approaches.

Pinning: The Role of Dynamic Hedging

Option pinning is primarily driven by the dynamic hedging activities of market participants, such as market makers, who hold options positions.

These individuals hedge their exposure to the underlying asset by buying or short-selling the stock.

This process creates a pinning force that pushes the price of the underlying asset toward the strike price of the option.

However, this force can only overcome regular trading activities in the underlying equity when the option is large, near-the-money, and has a short time to expiration.

As such, it typically requires there to be options markets with significant volume that have strikes close to expiration, often the same day (zero days to expiration, commonly known as “0 DTE”).

Tesla (TSLA) as a prominent example of option pinning

An example of a stock where option pinning is most notable is Tesla (TSLA).

Because the stock has been heavily promoted by its CEO, is very popular among individual investors, and has very high implied volatility for a large-cap stock*, it has a large and liquid options market.

As a result, it commonly finishes at or near whole numbers upon the Friday closing each week, reflecting the option pinning phenomenon.

* In Asia especially, some insurance products provide income by writing calls against long equity positions. Large cap stocks with higher implied volatilities are likely to be targeted for such a strategy because the options provide higher income potential and larger cap stocks are perceived to be more stable and liquid. As a result, this further illustrates the entire financial complex surrounding Tesla.

The Role of Market Makers

Market makers play a critical role in option pinning by dynamically hedging options they own.

By doing so, they can limit their directional risk (lower their delta) and capture the differential between the implied volatility and the realized volatility in the market.

They hope that this generates enough profit to offset the implied volatility they purchased.

When market makers systematically do this, their activities can dampen the volatility of the underlying equity, especially when the option is about to expire and is at-the-money.

The Impact of Charm

“Charm” or “delta decay” is a second-order option Greek, and it measures the change in delta with respect to time passing (all else being equal).

Delta is the amount by which an option’s price is expected to move for each $1 move in the underlying asset.

Let’s simplify these concepts and see how they interact.

• Delta: It tells you how much the option price changes if the underlying stock price changes by $1. So, if an option has a delta of 0.5, its price should increase by $0.5 if the stock price increases by $1.
• Charm: This tells you how much the delta will change as one trading day passes. It’s also known as delta decay because the delta of an option tends to decrease, or “decay,” as time passes.

Now, how does charm contribute to option pinning?

The market makers who sell options often hedge their risk by buying or selling the underlying stock in an amount corresponding to the option’s delta.

For example, if they sell an option with a delta of 0.5, they might buy 50 shares of the stock for every 1 options contract (representing 100 shares) they sell, to hedge their risk.

However, as time passes and we get closer to the option’s expiration date, charm causes the delta to change.

This means that the market makers need to adjust their hedges, buying or selling more of the underlying stock.

If charm is negative (which it often is), the delta will decrease, and the market makers will need to sell some of the stock they bought for their hedge. This selling pressure can push the stock price down.

On the other hand, if many options with a strike price above the current stock price are coming close to expiry, their deltas will also be decreasing due to charm.

Market makers, who initially sold these options and bought or sold stock to hedge to reduce their delta/gamma exposure, will now sell the stock as the delta reduces.

This selling pressure can push the price down closer to the strike price, contributing to the pinning effect.

So, in simple terms, charm describes how the changing delta – which is used by market makers for hedging – can create buying or selling pressure on the stock, contributing to the option pinning phenomenon as the expiration date approaches.

The Influence of Vanna

“Vanna” is another second-order option Greek, similar to charm.

It measures the rate of change in delta with respect to a change in volatility, assuming everything else stays the same. In other words, it tells you how much the delta of an option would change if volatility increases or decreases.

Volatility is a measure of the uncertainty or risk about the size of changes in a security’s value.

A higher volatility means that a security’s value can potentially be spread out over a larger range of values (thinking in terms of distributions). This means that the price of the security can change dramatically over a short time period in either direction.

In the context of option pinning, vanna becomes important because it describes how changes in perceived volatility of the underlying asset can influence the delta of options, and thus the hedging activities of market makers.

As mentioned, market makers typically hedge the options they sell by buying or selling the underlying stock, according to the option’s delta.

When the volatility changes, vanna indicates how much the delta changes, which in turn changes the amount of stock the market makers need to hold for their hedge.

For example, if the volatility decreases, vanna would typically cause the delta of out-of-the-money options to decrease (become more negative), and the delta of in-the-money options to increase (become more positive).

This would mean that market makers would need to sell some of their hedging stock for out-of-the-money options, and buy more hedging stock for in-the-money options.

This can cause the stock price to move toward the strike price of the options, therefore contributing to the option pinning effect.

In short, vanna describes how changes in the volatility of the stock can lead to buying or selling pressure from market makers adjusting their hedges, which can contribute to option pinning as the expiration date approaches.

Why Options Call Walls Cause Pinning

FAQs – Option Pinning

What is option pinning?

Option pinning is a phenomenon in the options market where the price of the underlying asset tends to move toward the strike price of a large, near-the-money option with a short time to expiration.

This occurs due to the dynamic hedging activities of market participants, most notably market makers.

What factors contribute to option pinning?

For option pinning to occur, the option must be large, near-the-money, and have a short time to expiration.

The dynamic hedging activities of market participants, particularly market makers, play a crucial role in driving the price of the underlying asset in the direction of the strike price.

How does dynamic hedging impact option pinning?

Market makers dynamically hedge their long options positions by short-selling the underlying stock.

This process creates a pinning force that pushes the price of the underlying asset toward the strike price of the option.

This force is most pronounced when the option is about to expire and is at-the-money.

What is the role of market makers in option pinning?

Market makers are key players in option pinning, as they dynamically hedge options they own to limit their directional risk and capture the volatility risk premium.

By systematically selling high and buying low, market makers’ activities can dampen the volatility of the underlying equity, especially when the option is about to expire and is at-the-money.

What is charm and how does it influence option pinning?

Charm is a Greek option metric that represents the change in an option’s delta as time passes.

As expiry approaches, charm contributes to the pinning effect by influencing buying and selling activity around the strike price, driving the market in the direction of the strike.

What is vanna and how does it affect option pinning?

Vanna is another Greek option metric that represents the change in delta as volatility falls.

Vanna influences the behavior of market participants as they adjust their positions based on changes in implied volatility.

Can option pinning be used as a trading strategy?

While option pinning is an interesting market phenomenon, it should not be considered a standalone trading strategy.

Markets makers understand the concept of option pinning well, but they also use software to help them execute their trading strategies. They can be difficult to execute effectively in a non-systematic way.

It is essential for traders to understand the various factors that influence option pinning, including dynamic hedging, delta, gamma, charm, and vanna.

These insights can help traders better navigate the options market, but they should also consider other factors affecting these options markets and the underlying asset when developing a comprehensive trading strategy.

Conclusion

Option pinning is a fascinating aspect of the options market that showcases how the dynamic hedging activities of market participants, especially market makers, can drive the price of the underlying asset toward the strike price of a large, near-the-money option with a short time to expiration.

The impact of charm and vanna further adds complexity to this phenomenon, creating a unique interplay between time, volatility, and price in the options market.

Understanding option pinning can provide insights for traders looking to better understand market behavior.