What is Pin Risk?
Pin risk is the risk an option seller has that the option they sold would expire in the money just before market close, thus pinning them in the position until the market opens again. Once pinned, the outcomes can range from maximum profit to substantial loss during a period of time where the option seller has little or no control of their exposure.
- Pin risk is the risk of an option seller holding an option that expires barely in the money as the market closes.
- This requires the option holder to now hold a position in the underlying until the market opens again.
- The subsequent risk of the market moving against them can wipe away their expected gains.
- The 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 after expiration. This risk is a complex puzzle because if the underlying expires even a small amount out of the money, the option writer's profit is total, but if the underlying is in the money even a small amount, the seller may be assigned an exercise of the option.
In this event, the option converts into a long (if a call) or short (if a put) position on the underlying. Since the underlying 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 bad the gap is, it could create substantial losses for the option seller.
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.
The term 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 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 significant risk to those trying to pin the stock, but if successful, it can represent substantial risk to the option sellers.
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 him or her 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, he or she 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 options writer in a long position that is potentially going to lose money.