Backtesting Pin Risk and Liquidity Implications
By Matt Amberson of ORATS
Friday, January 20th is an options expiration with big consequences for the market and individual securities. Even if you don’t trade options, the effect of options spills over to the stock market particularly on options expiration, and especially on this Friday.
At expiration, options are either worthless or converted into a long or short stock position. In the days leading up to expiration, a situation called “pin risk” can occur as investors hustle to hedge their options positions. Stocks with pin risk have a strike price close to the stock price with high open interest relative to other strikes. As the stock price fluctuates near the pin strike price, investor behavior tends to draw or “pin” the stock to the strike. There have been numerous academic papers written about this phenomena and we at ORATS have performed a backtest confirming this behavior and show an example as to why this might occur (see below).
The January Effect
January typically has the year’s largest number of pin risk events because the expiration has been open for trading longer than any other month and portfolio managers often use these options to hedge their annual performance. Long term or LEAPS options are created with expirations out as far as 2.8 years. The expiration for most LEAPS is the third Friday in January. Some of this January’s options have been open since 2014. This January has a much higher percentage of open interest than other months.
Open interest is created when an options trade is open and is reduced when an options trade is closed. This measurement is often ignored, but open interest is an important indicator for pin risk and market trading volume. In the top 5 stocks by volume expiring Friday, January’s open interest as a percent of total open interest is 43%. Compare this to a typical December expiration where 25% of total open interest was expiring. Thus, we expect this Friday to be an especially busy day of trading.
Pins This January
This January has a massive number of symbols meeting our pin risk requirements compared to other months. In fact, this month has nearly as many pin candidates as the previous 12 months combined. ORATS has set up requirements to identify a symbol with pin risk. First, the ticker had to meet stock price, volatility and option volume levels. Second, and most importantly, the pin risk strike had to be near the stock price with open interest at least three times higher than other strikes. These stocks, in theory, are set up for the stock price to drift toward the pin risk strike.
For example, Abbvie is one of the pin candidates this expiration with high open interest at the $60 strike compared to neighboring strikes. One reason there are so many options open around the money is that Abbvie has moved in a range around $60 for many months. Same with ABT, ABX and many of the total 69 symbols identified as having pin risk.
Backtesting Pin Risk
The hypothesis: if pin risk is true then the actual stock price range will be less than the market expects. On a perfect pin, the stock price settles right at the pin strike price. The market expectation of stock price range is represented in the straddle price of the pin risk strike. A straddle is the call plus put price at the same strike. This is not to say that a straddle is an appropriate strategy for all pin risk situations, but it is a convenient method for testing this hypothesis. There may be better risk-reward strategies like vertical spreads, butterflies, and calendars that may be more appropriate given the trader’s situation.
Four days before each expiration in 2016 we identified pin risk stocks and collected the price of the straddle. At expiration, we compared the stock price to the strike price and identified if the straddle was profitable. The results were that the actual range was less than the market expects by an average of 9% (over four days) and was less in 67% of the cases. The hypothesis that pin risk is true is supported by these results.
On 12/12/16 four days before December expiration, AAPL had 377k open interest on the 115 pin risk strike, more than 20 times as many as the 112, 113, 114, 116, 117 and 118 strikes. With the stock at $113.15, the 115 straddle was priced at $2.42. The stock went up and closed at $115.99 on expiration with the straddle worth $0.99 or $1.43 less than the market expected.
The pressure for AAPL to close near 115 can be explained this way. When AAPL is below the 115 strike, put holders realize that each option will convert to 100 shares of long stock after expiration. Not wanting to wake up Monday morning with thousands of short AAPL they start to buy the stock. As AAPL goes up past 115, the opposite is true: they will be long AAPL stock and need to sell. The call holders with the stock above the 115 strike now need to sell AAPL too. You may think that there are also an equal number of short options and you would be correct. The shorts, however, do not have as concrete of a solution to hedging their resulting stock position. They are at the mercy of the long holders of options as to whether the options will be exercised or not. This is a reason that shorts are not as aggressive hedging their stocks as longs around expiration. The shorts simply don’t know what their position will be as well as the longs.
Losing Liquidity After Expiration
The pin phenomena we have seen leads to natural option buyers and sellers around pin risk strike prices. This has macro effects and leads to more trading and tighter markets where there is more open interest. After January expiration, an inordinately large amount of options will leave the market and with them, natural liquidity. Shocks to the market after January expiration may see more movement and wider markets with the loss of liquidity than would have been the case with these natural options participants.
What to Watch This Expiration
January is a large expiration, not only in relation to other months but to other years. A large number of pin risk stocks will present opportunities for options traders. All this open interest expiring may 1) cause heavy trading volumes this week, and 2) lessen liquidity from the options market and the stock market for the weeks and perhaps months to follow. Both can lead to more volatility.
If you would like to see the backtest results or the currently pinned stocks, please contact me here.
Option Research & Technology Services (ORATS) is an independent options research firm offering the highest quality data and tools. For more visit www.orats.com