Stock options can represent valuable deals for investors. A stock option is a formal agreement that gives the buyer the right, or option, to purchase a specific quantity of stock in a given company for a predetermined price before a certain date. However, if options sellers engage in illegal stock pinning, stock options may become less valuable, depending on their prices.
How Options Work
Stock options may be given to employees or investors, or bought and sold on the open market. When a seller offers a stock option on the open market, the seller hopes that the share price will remain below the predetermined purchase price, known as the strike price. The buyer hopes that the share price will rise and make the strike price a good value upon exercising the option. Whether the buyer exercises the option or not, the seller earns money by charging a fee for the right to buy the option.
Stock Pinning Explained
Stock pinning is a theoretical phenomenon in which a stock's share price approaches the strike price in the days or hours leading up to an option's expiration. Options sellers can cause pinning by buying or selling large quantities of stock just before an option expires, causing the share price to change based on supply and demand in the market. Stock pinning is a form of market manipulation and is therefore illegal under the Securities Exchange Act of 1934. However, since pinning doesn't occur for every option and financial analysts use a variety of methods to measure and categorize pinning, it is difficult to prove. Prosecution for stock pinning is uncommon.
Setting Option Prices
Every stock option has two prices: the strike price, which is how much the buyer can pay per share upon exercising the option, and the flat fee for buying the option initially. When sellers are confident that they can manipulate markets through pinning to prevent options buyers from exercising options and buying stock for much less than its market value, the sellers can charge lower fees and still profit. Sellers set strike prices based on their expectations of changes in the stocks' value; those that engage in pinning could also account for how much they expect to be able to manipulate share prices through pinning.
Since stock options always expire on certain days of each month, pinning is confined to these dates. Stock pinning can be identified based on stock price changes that are out of the ordinary or different from changes on other days. Both buyers and sellers take on risk in an option transaction. However, it is difficult for buyers to know how pinning will impact share prices, how much a seller's fees and an option's strike price are affected by pinning or whether pinning is in fact a real phenomenon.
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