Let's Talk About Pin Risk - Part Two

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...Continued From Part One

Exercise Thresholds
Pin risk has become slightly easier to manage in recent years as thethreshold for automatic exercise (a.k.a. - exercise by exception) has decreased. Automatic exercise was developed as a way to expedite the laborious expiration process. In the old days, the burden of exercising options positions fell on the individual customers and traders. It was a complex and time consuming task. In today's market, though, much of that grunt work has thankfully been automated.

The current Options Clearing Corp (OCC)threshold for automatic exercise is $.05 for most equity options. Thistight threshold has eliminated much of the guesswork from managingpin risk. If the underlying closes more than a nickel away from the strike, you can be reasonably certain that you will be assigned on all of your contracts and plan accordingly.

Note: Your brokerage firm may utilize a differentexercise threshold. If you have any questions about whenyour options will be exercised, you should contact your broker formore information.


Time Is A Factor
One critical factor to consider when dealing with pin risk is time.Many novice options traders assume that the exercise decision is basedsolely on the closing price of the underlying. However, the exercise process does not end when the underlying closes on expiration Friday. Traders have a significant window after the close in which tomake up their minds about exercising their options.

If the stock is pinned, most experienced traders will watch for trendsin the after-hours market before deciding whether or not to exercisetheir options. The same holds true for hedging pin risk. If theafter-hours market is moving away from the pinned strike, hedging may notbe necessary.

Example 2
XYZ stock closes at $35 on expiration day. You are short 50 frontmonth 35 calls. The stock drops to $34.63 inthe after-hours market. What should you do?

The correct response to this scenario is quite straightforward. You should do nothing. The underlying is trading below the strike price of your calls, so assignment is highly unlikely. Of course, human nature is a fickle thing,and some assignments may still trickle through. However, given the position ofthe stock, any assignments could be easily and profitablyclosed out in the open market.

Nightmare Scenarios
There are many nightmare scenarios where the potential impact of pin risk issignificantly amplified. These include earnings announcements and other events that have the potential to significantly move the underlying after the close on expiration Friday. The risks associated with being caught naked long or naked short prior to an earnings announcement are obvious, and they can be particularly unpleasant.

If you are trading options on a stock that announces its earnings on expiration Friday, or if you have reason to suspect significant swings in the underlying after the close on expiration Friday, then you should endeavor to close out your positions in any at-risk strikes.
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