Options

The effect of stock pinning upon option prices

The existence of standardised expiration dates for listed equity options affects the prices of underlying stocks close to these dates due to hedging activity. Here, Hari Krishnan and Izzy Nelken demonstrate that the effect is significant in US markets and show how to account for it in pricing models

he process of pinning is frequently mentioned in stock traders lore, but its effect upon the price of an option is not well understood. Some traders believe that on days when equity options expire (typically the third Friday of a given month), many stocks seem to close near a multiple of $5. In this paper, we give statistical evidence for the existence of pinning, and develop an option-pricing model that incorporates this phenomenon. We conclude that, near expiration, there is a discrepancy between the Black-Scholes price of an option and the price of an option whose underlying stock has a higher than normal probability of being pinned. We analyse the various cases (eg, when the pinned price is cheaper than the BlackScholes price) and provide intuition for the price discrepancies.

What is pinning?
Many stock traders have observed that, on expiration Fridays (days when exchangetraded equity options expire, typically the third Friday of a calendar month), an unusually large number of stocks seem to close near a multiple of $5 (eg, near $95, $100, $105, ). These $5 multiples correspond to strike values for equity options. A possible reason for this phenomenon is that a few market participants have large short gamma positions. For example, they may have sold a large number of straddles (combinations of puts and calls at the same strike). These traders delta hedging activities cause the stock price to move towards the strike. For example, consider a trader who is short straddles at struck at $100. As the stock moves from $102 to $101, the trader is inclined to sell more stock, thus pushing the stock price even lower. If the stock continues to drop and reaches $99, the trader will be inclined to purchase shares, driving the stock price up. There has been much academic work on expiration-day effects. For example, Stoll and Whaley (1987) report large trading volumes in the last hour of trading on expiration Fridays. This research suggests that stock price dynamics may be different on expiration Fridays than on other trading days. Other papers, such as Roder, K and Bamberg (1996), Schlag (1996) and Merrick also investigate price dynamics on expiration days.

were to evolve randomly and prices were continuous, then the stock would be expected to close within 0.25 of a $5 strike 2.25/5 of the time. First, let us consider non-expiration days. As can be seen below, MSFT closed within 0.25 of a strike price 13.52% of the time. This is higher than the expected 10%. A number of plausible explanations may be given for this: stock prices move discretely, in increments of 1/32; stop-loss trades are typically executed at integer values; a stock with a reasonably high spot price (greater than $10, say) tends to move in increments of 1/16 or even 0.25. Suppose, then, that the change in a given stock were never smaller than 0.25, and that the initial stock price were an integer multiple of 0.25. Then the stock would trade of 3/20 = 15% of the time within 0.25 of a strike price, which more closely corresponds to the MSFT data. It is instructive to compare the expiration Fridays (the columns on the right of table 1) with other trading days. On expiration Fridays, MSFT landed within 0.25 of a strike 23.29% of the time, nearly twice as frequently as usual. These results are not unique to MSFT, and indeed pinning seems to occur for a variety of stocks which have actively traded options. We can show that pinning is a statistically significant phenomenon using a simple price transformation and the Wilcoxon rank-sum test. If the terminal price lands within 25 cents of a strike, we assign a 1 to the price, otherwise a 0. In this way, we can compare the closing prices on expiration Fridays and other days. If pinning is truly observable, the mean of the transformed prices should be larg-

1. Expiration Fridays comparison

MSFT Non-expiration day (2959 days) Pinned 123 235 400 715 % Pinned 4.16% 7.94% 13.52% 24.16% Expiration Friday (146 days) Pinned 13 20 34 47 % Pinned 8.90% 13.70% 23.29% 32.19%

Statistical evidence of pinning

In this section, we provide a concrete example where pinning demonstrably occurs. Our example is fairly typical for optionable stocks. We notice that pinning seems to have increased in recent years along with option trading volume. To simplify our analysis, we assume that strike prices occur at $5 increments. In reality, there are often fractional strike prices due to stock splits and other corporate actions. To check our assumptions, we define various degrees of pinning for a given stock: A. stock closes within 1/16 of a strike B. stock closes within 1/8 of a strike C. stock closes within 0.25 of a strike D. stock closes within 0.5 of a strike In the table below, we consider Microsoft (MSFT) closing prices over the interval January 1990June 2001, distinguishing expiration Fridays from non-expiration days (all trading days except for expiration Fridays). We have chosen MSFT since it is a very liquid stock whose options have been traded very actively in recent years. For the purposes of illustration, we describe scenario C in detail. If a stock

90-Now 1/16 1/8 0.25 0.5

er on expiration Fridays than other days. Using the Wilcoxon rank-sum test, we generate a p value which is smaller than 0.01, so that the alternative hypothesis gives more than a 99% chance of being correct. (We have not applied the more common Student t-test since our price data is discrete and the data sets are not normally distributed.)

Option pricing and pinning: an idealised model

In this section, we propose a diffusion model for stocks which incorporates pinning. We will use this model to price options. Our model makes two simplifying assumptions: The stock is certain to get pinned on expiration. When the stock gets pinned, it goes to the strike price exactly (eg, it does not close within 0.25 of the strike). In the Black-Scholes formulation, the price St of a stock evolves according to the equation
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St + = St e + 0

where St is the current stock price, is the drift rate, is an increment of time, is the stock volatility and 0 ~ N(0,1) is a normally distributed random variable. In a risk-neutral world, the drift is given by = r q 2/2, where r is the risk-free (continuously compounded) interest rate and q is the dividend rate. Note that the traditional Black-Scholes equations do not take pinning into account, so that is both time- and price-independent. In order to force the price path St to land on a strike (here assumed to be a multiple of $5), we need to constrain the drift of the above process. In our case, the = (t,T,P drift ,Pt,, 0) depends on price, time and volatility, and it is stochastic. Our model is constructed in several steps: 1. Starting at St, we draw a random number 0 ~ N(0,1) and calculate the terminal price ST = St e
( T t )+ 0 ( T t )

1. A 100 call option, two days to expiration, 30% volatility across a range of stock prices
6 5 4 3 2 1 0 90 95 100 105 110 Normal Black Scholes Five round

Each time we run a simulation, we generate a different 0 and hence a different ST. 2. For a given 0, we choose the closest strike to ST. We denote this strike by F(ST). Since 0 is a random variable, a stock can theoretically get pinned at any strike. However, Step 1 ensures that the probability that ST will be pinned at a nearby strike is large (relative to a strike that is far away), for a reasonable . (It is easiest for a market participant to drive the price of a stock to the nearest possible strike.)
We compare the five round process with the Black Scholes price. (Also included is a normal simulation process to show its excellent agreement with Black Scholes.)

which connects S to F(S ). 3. We next create a (simulation-dependent) drift T T Thus, we evolve ST according to the process
S t + = S te + 1 where F(ST ) = ln (T t ) ST and 0 ~ N(0,1) is a random variable independent of 0. It is important to realise that we need two random variables, 0,1, to evolve S from t to t+. 0 decides which strike the price should shoot at and 1 generates a diffusion around this line. Our process can be loosely thought of as a generalisation of a Brownian bridge with a lattice of boundary conditions.

2. A magnified version of the central part of chart 1

2.5 2 1.5 1 0.5 0 97 98 99 100 101 102 103 Normal Black Scholes Five round

Open interest
Our model does not incorporate the open interest of options with differing strikes. Several market participants as well as our anonymous referee correctly mentioned that stock prices are more likely to be pinned to strikes with large open interest. However, in our opinion: It is difficult to obtain historical open interest data going back ten years, and consequently, we cannot test our model over a large data set. Pinning activity occurs only during the last few trading hours on an expiration Friday. It would be difficult and expensive to move the stock by more than $5 in such a short amount of time. It is hard to say for any one particular strike whether a given market maker is long or short gamma. As we do not know on which side the market makers are on, we cannot say with any certainty whether pinning would, in fact, occur to that strike. For these reasons, we feel that adding open interest information is difficult, and may not contribute substantively to the model.

It is clear that the Black Scholes is very close to the simulation. The five round process, on the other hand, is significantly different

Computational results
Charts 1 and 2 show option prices for a call option with two days to maturity. We assume that the volatility is 30%, the risk free rate is 6% and that the underlying stock pays no dividends. The option prices in charts 1 and 2 have been obtained using three processes: A Monte Carlo simulation of a traditional stock price diffusion that does not incorporate pinning. The Black-Scholes price, calculated analytically. The process described in the section above (generating what we will from now
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on call a five-round price, since we are forcing the stock to a strike). As expected, we get an excellent agreement between the traditional Monte Carlo simulation process (1) and the Black-Scholes formula (2). However, the pinned simulation process (3) gives results that are significantly different. For at-the-money options, the five-round process generates a lower price than the traditional Black-Scholes model. If a stock is trading at $100 near expiration, there is a large probability that it will close at $100, and that the option will expire worthless. On the other hand, if the option is slightly in the money (eg, if the stock price is $104), the five-round process implies that the option is more expensive than the traditional model. If the share price is at $104, the traditional model will price the option at about $4 (since there is very little time premium). On the other hand, the five-round process will tend to drive the share price to $105. Thus the option should cost somewhere between $4 and $5. Although put prices are not given in Chart 1, these can be calculated directly by
We can show that put-call parity holds for the pinned process using the following argument (which can also be found in Hull [H]): Consider the two portfolios at time t: Portfolio A one European call option plus an amount of cash equal to xer(Tt). Portfolio B one European put option plus one share. On expiration, at time T, both of these portfolios will be worth max(ST,X), so that their values at time t must be the same. Put-call parity does not depend upon the underlying stock price process. We have also verified that put-call parity holds in our numerical simulations
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simulation, or using put-call parity.1 It is also interesting to compare Black-Scholes and five-round option prices for a fixed initial price and a range of volatilities. As volatility increases, one would expect the difference in prices to be proportionately closer, since pinning has less of an impact on the underlying stock evolution. Indeed, we have used simulation to verify that the difference in option prices converges to zero as volatility increases. We note that pinning has less of an impact on the price of an option if the stock has a high volatility, or the option has a long time to expiration. This small difference in option prices does not imply that the stock is less likely to get pinned. Rather, even if the stock is pinned, we do not know to which strike. The uncertainty causes the options price differential to diminish. Thus, the pinned price process with high volatility and long time to expiration is less predictable, and behaves like a highly discretised random walk, which results in an option price close to Black-Scholes. The price discrepancies in Chart 1 are larger than would be expected in real life, since a particular stock will not always be pinned. However, if there is a larger than normal probability that a stock will be pinned, the true price of an option will lie somewhere in between the Black-Scholes and five round prices. Thus, the difference between the Black-Scholes and five round prices given in the graph should be viewed as upper bounds, and our results should be interpreted qualitatively. We have also made the simplifying assumption that stocks are pinned to the strike price exactly. This does not account for the fact that a pinned stock may close near (but not at) the strike price. It would be interesting to extend the work to cover this.

References
Hull, J Options, Futures and Other Derivatives Prentice Hall. Merrick, J Early unwindings and rollovers of stock index futures arbitrage programs: analysis and implications for predicting expiration day effects 87-16 / Federal Reserve Bank of Philadelphia (RePEc:fip:fedpwp:87-16) Schlag, C Expiration Day Effects of Stock Index Derivatives in Germany European Financial Management Journal 1 (1996), pp. 69-95. Roder, K and Bamberg, G Intraday-Volatility and Expiration Day Effects on the German Stock Market Kredit and Kapital, 2 (1996) , pp. 244-276 Stoll, HR and Whaley, RE Program Trading and Expiration-Day Effects Financial Analysts Journal, March/April 1987

Conclusions
In this paper we provided concrete statistical evidence for pinning with certain stocks and developed an alternate model governing the price dynamics of a pinned stock. Using this model, we simulated the payoff structure of a call option for a range of volatilities and spot prices. Our analysis suggests that a low volatility stock is more dramatically affected by pinning. There are situations where the pinned price is significantly different to the traditional Black-Scholes price. We have also shown how to extend our model to the case where a stock has a positive probability of being pinned, but is not guaranteed to land near a strike. Hari Krishnan is vice-president of the GWMS division, Morgan Stanley, Chicago. E-mail: hari.krishnan@morganstanley.com Izzy Nelken is president of Super Computer Consulting, USA. E-mail: izzy@supercc.com, www.supercc.com

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