What Is Pin Risk?
Pin risk is the uncertainty that arises over whether an options contract will be exercised (or assigned) when the expiration price of the underlying security is at or very close to the option's strike price. This is known as pinning a strike; for example, if XYZ stock expires at $50 the 50-strike would be pinned.
Pinning a strike imposes a risk for options traders, who may become uncertain about exercising their long options, which have expired at the money (ATM) or very close to being at the money. Part of their hesitancy is also due to the simultaneous uncertainty of the number of similar short positions they will be assigned on. Because of this, options holders may experience losses when the market opens on the next trading day based on how many long contracts they exercised and how many shorts they ended up being assigned on.
- Pin risk is the risk to options traders that the underlying security will close at or very close to the strike price of expiring options positions held.
- The risk is that it is unclear how many long options should be exercised and how many shorts they will be assigned on.
- This uncertainty can create positions that are implicitly held unhedged over the weekend, with the risk of the market moving against them and wiping away their expected gains.
- A pinned position is hard to effectively hedge against.
Understanding Pin Risk
Pin risk is the risk an option seller experiences as expiration approaches and the price of the underlying asset is near to being in the money (ITM) after expiration. This risk is actually a complex puzzle because if the underlying expires even a small amount out of the money (OTM), the option writer's profit is the total premium collected, but if the underlying is in the money even a small amount, the seller may be assigned by a long who exercises that option.
In such an event, the option converts into a short for the seller (if a call has been sold) or a long (if a put) position on the underlying. Since the underlying security itself will not trade until the market opens, the option seller is now exposed to the possibility that the underlying will gap unfavorably against them. Depending on how large the gap is, it could create substantial losses.
In the moments before the market closes ahead of expiration, the option seller does not know exactly how to hedge the position heading into expiration, and almost any hedge they choose will substantially erode their potential profits.
Pinning refers to the potential for institutional option buyers to manipulate price action in the underlying as options expiration approaches. If these option buyers face the potential for a total loss of the option, they may try to pin the stock to a price just in the money by strategically entering buy orders at the last minute before the close. If unsuccessful, these attempts represent a significant risk to those trying to pin the stock, but if successful, it can represent a substantial risk to the option sellers.
Pinning the strike happens most frequently when there is a large amount of open interest in the calls and puts of a particular strike as expiration approaches.
Pin Risk May Result in Market Risk
It is worth restating that the risk to the options seller is that they do not know for certain whether the holder will exercise the options, leaving them with either a long or a short position in the underlying. Putting on a hedge against such a position will also leave the options seller with market risk if the option is not exercised.
Therefore, neither party knows exactly how to hedge their positions. At one stock price, they have no need for hedges, but at a different price, they could have exposure to market risk, typically over a weekend, that they will have to buy or sell the underlying when trading resumes Monday to flatten out the position.
For example, say the purchaser of a $30 call wishes to exercise the option to buy the stock if it closes at this price at expiration. If the position is not covered by the writer, it will end up with a short position in the stock and all the risks associated with this position. The reverse is true for a put, leaving the writer of the option with a long position that is potentially going to lose money.
Example of Pin Risk
Let's say XYZ stock is trading at $30.10 on the last day of trading, and there is a great deal of open interest in the 30 strike calls and puts. Say that Trader A is long the calls and Trader B is short calls. As the trading day comes to a close, the stock falls steadily to exactly $30.00, where it closes.
Trader A would normally exercise the options if they were ITM, profiting from the difference in the strike price (where they would purchase the shares) and the market price where the shares could be sold. But, at exactly $30 there is no profit to be had and so Trader A is uncertain whether to exercise the contracts. Trader B should expect the options to expire worthless, but since they do not know if or how many calls Trader A will exercise, they cannot be sure this will be the case and, if assigned, instead of worthless options they would receive a short position in XYZ shares from $30.00.