Thursday, 25 February 2016

PIN RISK

AN EXPIRATION CONCERN
Option sellers who hold their short positions until they expire understand the basics: An option owner has three choices. As a result, the option seller can expect:
·         The option owner to exercise his/her rights and (as the option seller) to be assigned an exercise notice whenever the option is in the money when expiration arrives.
·         To see all out-of-the-money options expire worthless.
The astute reader may ask what happens when the stock closes exactly at the strike price on expiration Friday.
When that happens the stock is said to be “pinned” to the strike and it represents uncertainty for the option seller. Note that the option owner has no such uncertainty because he/she has the decision-making power and may exercise the options or allow them to expire worthless. The option seller (who does not cover the short option) must wait for the option owner's decision.
That is where uncertainty (risk) comes into play.
Most of the time when the stock is pinned to the strike price, the person who owns the option chooses not to exercise and the option expires worthless. However, there is times when the option owner must exercise in order to maintain a long (or short) equity position in his/her portfolio. In addition, market makers often exercise ATM options at expiration in order to remove all risk of owning positions that are too long or too short. It is acceptable for any big trader to be short 10,000 shares of stock, hoping for a decline -- as long as he/she owns 100 calls to mitigate upside risk. When the stock get pinned to the strike price of those 100 options, the trader must exercise all 100 calls to cover the short stock position.
That trader cannot afford to take the risk associated with holding the short position over the weekend. These situations are not rare, so do not be surprised when you are assigned an exercise notice on an option that you thought would expire worthless.
The simplest path to eliminating pin risk for any position is to close all such ATM short option positions before the market closes on expiration Friday
These options will not cost more than $0.05 when the trade is made late in the day and the option is out of the money by a penny or two. Being forced to spend that $5 plus commissions per contract is a nuisance, but it does prevent an unpleasant surprise Monday morning. Sometimes stock prices gap and the Monday morning opening price may be quite different from its closing price on the previous Friday. Thus, when you own a stock position over the weekend, you are at risk of incurring a substantial loss (or profit). Intelligent traders avoid that risk. Note that investors may prefer to own the shares, when traders prefer to own no position.
There are enough risks associated with options trading and investing that there is no need to add another. If you do not want to be worried about your post-expiration position, then take the simple action of closing the position late in the afternoon on expiration Friday. For example, if you write covered calls and do not want to sell your stock when it is exactly at the strike price, then cover the short call and sell a new call option prior to expiration.

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