What is Pin Risk
Pin risk is the uncertainty that the writer of an options contract faces when the price of the underlying asset trades at or very near the strike price just ahead of options expiration. The risk comes from not knowing if the underlying will close in- or out-of-the money and, in turn, not knowing if the holder will exercise the option. Therefore, the options writer (seller) does not know exactly how to hedge the position heading into expiration.
BREAKING DOWN Pin Risk
The term "pinning" refers to the price action in stocks as options expiration approaches. Because the stock trades very near to the strike price of the option, some traders and market makers will have an incentive to keep the underlying stock above or below that strike price. They try to "pin" the stock to a price.
Stocks can oscillate above and below the options strike price as expiration approaches. Within minutes of the close on the final trading day before expiration, it is very possible to see a stock jump both higher and lower around the strike. This creates uncertainty for both options buyer and seller, although the seller has even more risk, because he or she cannot predict if the option will expire in-the-money or out-of-the money. For the former, the option may automatically exercise.
Pin Risk May Result in Market Risk
It is worth restating, that the risk to the options seller is the he or she does 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, in fact, not exercised.
Therefore, neither party knows exactly how to hedge their positions. At one stock price they have not 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.