Pin risk is a condition that arises when the price of underlying security becomes less volatile than the premium on an option contract. Pin risk can be dangerous for investors who have short positions in options that have strike prices near the current market value of equity. Find everything you should know about pin risk and how you can avoid it for success in your investment.
All You Should Know About Pin Risk
Pin risk refers to the uncertainty that emerges when the underlying securities’ termination cost is at or near the strike price of the option contract. The stock will expire at the specified price when a strike is pinned. For instance, if a stock (let’s call it XYZ) expires at $50, the 50-strike is pinned.
A danger for options traders is that they may get uneasy about executing their long options. Options that have either ATM or expired at the money. A portion of their reluctance can also be attributed to the synchronous uncertainty surrounding the set of common short positions to which they will be allocated. That means option holders could suffer losses whenever the market reopens the following trading day. It depends on the number of long contracts they executed. It also depends on the sum of short contracts allocated during the previous trading day.
Understanding Pin Risk
Pin Risk Overview.
Pin Risk Overview. Everything You Should Know
An option seller faces pin risk. Because the underlying asset’s price approaches expiration and the option is nearing the money (ITM). This risk is quite complicated if the underlying expires even slightly out of the money (OTM). An option writer’s revenue is equal to the total premium collected. However, if the underlying expires even slightly in the money (ITM), the seller can be assigned by long exercising that option.
The option changes into a short position for the seller (when a call is sold) or a long position (when a put is sold). Moreover, because the underlying asset will not sell till the market goes up, an option seller is vulnerable to the potential that the underlying would gap negatively in their favor. Significant losses may result depending on the size of the gap.
Option sellers are unaware of how to hedge their positions heading into maturity in the few minutes before the market closes. Any protection they choose significantly reduces their prospective earnings.
As the expiration of an option nears, institutional option buyers can control the price action of the underlying by pinning the option’s price. Suppose these option buyers face the possibility of losing their entire investment in the option. In that case, they may attempt to pin the share to a value just in the money. They can do it by deliberately placing buy orders at the last moment before the expiration of the option. If failed, these attempts to pin the stock offer a massive risk to those attempting to do so. If successful, they can represent a considerable risk to option sellers.
Consider the following scenario: XYZ stock trades at $30.10 on the last trading day of the month. There is a significant amount of long positions in the 30 strike puts and calls. Now consider the following scenario: Trader C is long calls, and Trader D is short calls. While the trading day closes gradually, the stock continues to decrease slowly until it reaches precisely $30.00, which closes.
The typical scenario for Trader C would be to execute the alternatives if they were in the money. Earning from the difference between the strike price (at which they could buy the shares). Plus the market price (at which they could sell the shares). However, at precisely $30, there’s no money to be gained. As a result, Trader C is unsure whether or not to execute the options. Trader D should anticipate that the alternatives will end valueless. They don’t know the number of calls Trader C exercises. That’s why they cannot be sure that this could be the case. If they are assigned, they would get a short position in the XYZ shares starting at $30.00, rather than worthless options.
Easy Ways to Avoid Pin Risk
If you want to avoid pin risk, you want to follow the instructions below.
- Do not enter spreads
- Spreads must be closed before expiration, regardless of anything (and take X percent profit programmatically).
Put the expiration of the lengthy leg one week later on the calendar. That is most likely the most accurate characterization of a diagonal spread. According to calculations, you would receive a lower premium having zero pin risk. That may or may not be a good trade-off in this case.
To prepare for the possibility of creating a newer spread immediately and providing coverage in the event of pinning, purchase a new lengthier leg close to or at its expiration.
It is not always necessary for significant events to be precipitated by news coverage. The crowded “Reddit meme” trades, such as GameStop (GME), have been causing considerable volatility in a small number of companies, particularly around option expiry timeframes.
Even if you have open long or short options bets that are about to expire, you won’t finish when the market closes on Friday. If you own long positions, you may discover opportunities to extract further profits. Even if you’re short, you may make an educated guess. Whether somebody who’s long might opt to make a decision contrary to the automatic-exercise principles.
It is possible to reduce the likelihood that you will make a mistake when buying or selling stocks (or not when buying or selling shares when you expect to make a mistake).
Use the examples as a compelling argument for why you should invest a cent in covering the expiration of your shorts. Even if you believe they are likely to become worthless. It’s a small price to pay for a piece of mind. If you can sell them again for 10 cents, you’ve probably already made a profit on the sale.
You may be the one to turn off the monitors and go out for a beer if you do not have any long-term babysitting options.