Papale on Pin Risk

Back when I was a kid, there was a show called “Mr. Ed”.  Ed was a talking horse but only talked to his owner, Wilbur.  No one else knew he talked.  Pretty talented horse.  However another talented horse has shown up in Indiana named Justin.  Justin’s talent?  Painting.  He has produced a self portrait as well as several other works.  The first sold for $15 dollars but newer ones are now going for hundreds.  First Mr. Ed, now Justin.  Lots of 4 legged talent out there.  I have an old dog named Kahlua.  I have a feeling she is a sculptor.  Opening bid – $100.

As we head into expiration, most of the time we tell folks to close out front month options and avoid the higher risks associated with expiration week.  However, for those that trade this week, along with the higher “greek” risks,  you must be aware of pin risk.  Pin risk is where an underlying settles right at a strike on expiration.  This is not a problem if you trade a cash settled product such as SPX or OEX.  In those type products cash is simply credited or debited to your account based on how far your option is from underlying settlement.  There is no delivery of an underlying.   However, for stocks and futures where you do take or deliver the underlying, pin risk can be a source of uncertainty for options traders.

For example, if you are short 10 WMT 70 calls and on expiration the stock closes at 70, you cannot be sure if you are going to be assigned on your calls or not.  When a stock settles on the strike, the option holder has the right (as always) to determine if he wants to exercise his calls.   In this case, his decision is not determined by any intrinsic value of the option but rather where the stock is likely to open on Monday morning following expiration.  If he thinks the stock will open higher, he might exercise his calls and own the stock at 70, if not, he may not.   And since he cannot be sure how many calls he will be assigned and hence what his position will be, it can be difficult to manage risk going into the weekend.   For nearly all traders, the smart play is to close out any non cash settled option that is near a strike price on expiration day and not have to deal with  this type of risk.

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