The Role of Market Makers in Pinning

The Unseen Hand of the Market Maker

Retail traders often view the market as a level playing field, but the reality is that there are large, sophisticated players who have a significant influence on price movements, especially around expiration. These players, known as market makers, have a very different set of incentives and risk management techniques than the average retail trader.

A market maker's primary role is to provide liquidity to the market. They do this by quoting both a bid and an ask price for a particular security, and they are obligated to honor those prices for a certain number of shares. In the options market, market makers are the ones who are on the other side of most retail trades. When you sell an option, there is a good chance that a market maker is the one who is buying it.

The Market Maker's Hedge

Market makers are not in the business of making directional bets on the market. Their goal is to profit from the bid-ask spread and to remain delta-neutral at all times. This means that for every option they buy or sell, they will immediately hedge their position by buying or selling the underlying stock.

For example, if a market maker buys a call option with a Delta of 0.50, they will immediately sell 50 shares of the underlying stock to hedge their position. If the stock price goes up, the Delta of their long call will increase, and they will sell more stock to remain delta-neutral. If the stock price goes down, the Delta of their long call will decrease, and they will buy back some of the stock they had sold.

This constant buying and selling of the underlying stock by market makers is what is known as "gamma scalping." They are constantly adjusting their hedge to profit from the small fluctuations in the stock price.

The Gamma Trap

Around expiration, when the Gamma of at-the-money options is at its highest, the activity of market makers can have a significant impact on the price of the underlying stock. If there is a large open interest in a particular strike price, the market makers will have a large position that they need to hedge. Their hedging activity can create a "gamma trap," where the stock is drawn to the strike price like a magnet.

For example, if there is a large open interest in the $100 strike calls, the market makers will be short a large number of those calls. As the stock approaches $100 from below, the Delta of their short calls will increase, and they will have to buy more stock to hedge their position. This buying pressure can push the stock up towards $100. Conversely, if the stock approaches $100 from above, the Delta of their short calls will decrease, and they will have to sell stock to reduce their hedge. This selling pressure can push the stock down towards $100.

This is why stocks often seem to be "pinned" to a particular strike price at expiration. It is not necessarily manipulation in the illegal sense, but rather the natural consequence of market makers hedging their large positions.

The Retail Trader's Disadvantage

For a retail trader who is short an option near the strike price, this can be a very dangerous situation. They are on the opposite side of the market maker's trade, and they do not have the same ability to constantly adjust their hedge. They are at a significant disadvantage, and they are at risk of being "gamma scalped" by the market makers.

This is why it is so important for retail traders to be aware of the role of market makers and to avoid situations where they are exposed to high levels of Gamma risk. The best way to do this is to close out short option positions before expiration, especially when there is a large open interest at the strike price.