Let's Talk About Pin Risk

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It's expiration week and once again our email is full of questionsabout pin risk. If you're one of the many people who have asked us about this subject, or if you're just curious what all the fuss is about, then this article is for you.

The Bane
Pin risk has been the bane of options traders for decades. Like themythical werewolf of old, this rough beast rears its ugly head once a month to wreak havoc among the unwary.

Unfortunately, pin risk is not triggered bythe rise of the full moon and silver bullets will do nothing to stop it. Instead, you will have to rely on clever position management (and a dash of luck) if you want to protect yourself against this potentiallydevastating phenomenon.


What Is Pin Risk?
Before we go any further, we should define a few terms:

• Pinned - When the underlying closes at or near the strike price of an option, it is said to have pinned on that strike.
  

• Pin Risk - The risk that option sellers face when the underlying pins on a strike.
  

Why Is It So Dangerous?
Pin risk involves a high degree of uncertainty. During expiration week,an experienced options trader only has to glance at his position tounderstand how his risk will change after expiration. A quick rundownof each strike will show him which options are in-the-money and whichoptions will expire worthless. He can then plan for any post-expirationchanges to his risk profile.

But what if the underlying is hovering near a strike on expiration day?Suddenly, the entire risk profile of his position changes. Let's take alook at an example:

Example 1
XYZ stock closes at $35 on expiration day. You are short 50 front-month 35 calls. What should you do?

If the stock had closed at $36, then your decision would be simple. Thecalls would be automatically assigned and you would have a shortposition of 5000 shares. This foreknowledge makes it easy to plan aheadand hedge the risk posed by this short position.

However, when the stock closes at or near a strike, there is much moreuncertainty and therefore much more risk. With the stock at $35, youessentially have three choices.

• Do nothing and hope that you aren't assigned on your calls. - The risks associated with this strategy are obvious. In a worst case scenario, all of your short calls could be assigned, leaving you with a naked short position of 5000 shares. This position would then have to be carried until the following Monday before it could be covered.
  

• Hedge part of your position and hope for the best - This is the choice of most traders. It is impossible to accurately predict the behavior of your fellow market participants. They may decide to exercise options that are only $.01 in-the-money or choose not to exercise options that are far more valuable.  The best that you can hope for is to make a reasonable estimate of how many contracts will be assigned and hedge accordingly. As a rule of thumb, many traders choose to hedge half of their position, cutting their overall risk exposure by 50%.
  

• Hedge the entire position and hope that you are assigned on all 50 contracts - This can be just as dangerous as doing nothing. If you end up not being assigned on any of your contracts, then you will have created a naked long position of 5000 shares.
  
  

Note: Pin risk is not limited to short call positions. It alsoapplies to short put positions, with the obvious caveat that anyassignment will create a long position in the underlying instead of a shortposition.

Continued In Part Two...
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