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volatility is like energy

Podcast 4: Feb. 15, 2010
Pin Risk
Most of you know that the last trading day for equity options is the third Friday of the expiration month so that means the last day to buy, sell, or exercise your February options will be this Friday, February 19. So I thought this would be a great time to talk about one of the most misunderstood option risks that tends to occur at expiration, which is called pin risk, that’s p-i-n risk, which is in reference to the underlying stock’s price getting stuck or pinned to one of the option strike prices at expiration. In many cases, it will be the option strike with the highest open interest but not always.
First, let’s understand a little more about what pin risk is. For example, let’s say that ABC stock is trading near $50 at expiration. It may be slightly higher or lower – perhaps within a couple of dollars on either side of $50 – but it’s pretty close to $50. In many cases at expiration, you will see the underlying stock’s price get pulled right to $50 as if that price were a magnet. The stock’s price gets drawn to it and can’t escape the invisible gravitational force surrounding it. In option trading terms, we’d say the stock is getting pinned at $50. Pin risk is a widely known phenomenon among professional option traders; however, many retail investors are unaware that it exists and do not understand the risks it presents.
How does pin risk happen and why is it a risk? Pin risk tends to happen at expiration as option traders close out their options as the closing bell draws closer. Of course, as retail investors close their positions someone must be taking the other side of the trade. Rarely is it ever another retail trader since the option is in the final minutes of its life. Instead, it is usually a market maker on the opposite side of the transaction who will hedge their transactions with the retail traders and that’s what causes the stock’s price to get pinned.
To understand why, let’s assume ABC stock is trading for $52 near expiration. Retail traders who are long the $50 calls will sell the calls to close in order to collect the $2 intrinsic value. Of course, that means the market maker must buy the calls in order to complete the transaction since there must be a buyer for every seller. If you’re selling, he must be buying. As the market maker buys the calls, he will simultaneously short 100 shares of stock for each call option contract he purchases. Why?
The reason is he will mitigate his stock price risk. For example, if the stock price rises 10 cents, he’s make 10 cents on the call option but lose 10 cents on the short stock position for no net gain or loss. The opposite will occur if the stock price falls. By shorting shares of stock, the market maker ensures he has no price risk.
In addition though, by shorting shares of stock, the market maker also places selling pressure on the $52 stock price thus driving it down towards $50.
What happens if the stock’s price falls significantly and drops below $50? In that case, the market maker’s long call option he purchased from the retail trader now appears that it will expire worthless. The market maker will simply buy shares of stock to cover the stock positions he previously shorted. Buying shares below $50 has the tendency to drive the stock price up towards $50.
So anytime the stock price is above $50, the market maker will be shorting shares and drive back towards $50. And when the stock price is below $50, the market maker will be buying shares and driving the price up towards $50. Again, it is the market maker’s hedging transactions that cause the stock to get pinned at $50 in this example.
Of course, a similar argument holds for puts. If ABC falls below $50, retail option traders who are long the $50 puts will seek to sell them to collect the intrinsic value. The market makers must, in turn, buy the puts and will simultaneously buy shares of stock to hedge the trade against stock price risk. The market maker’s actions of buying shares will drive the stock price up towards $50. And if the stock price rises above $50, the market maker will sell the long shares of stock, which drives the stock price back towards $50.
The main point to understand is that as retail traders sell their long calls and puts near expiration, market makers must take the opposite side of the transaction and will hedge those purchases by either buying or shorting shares of stock. The purchases and sales of stock, in turn, drive the stock towards the option strike price.
As I mentioned earlier, many times the stock price will not get pinned to the strike that is the closest to the current stock price but, instead, to the strike that has the highest open interest. The reason should be fairly clear now that you understand how pinning occurs. The strike with the highest open interest will create the most purchases and sales of stock at that strike. It is for this reason that many traders view the strikes with the highest open interest as phantom support and resistance points. However, most of the time, the strike that is closest to the current stock price is usually the option with the highest open interest so the two are usually synonymous.
It’s crucial to understand that pinning is not a necessary outcome. If big news hits as expiration draws closer, you could see the stock price rise or fall through many strikes.

As always, overall supply and demand for the shares is what determines the price. Pinning just aids in providing supply and demand in the absence of news. It creates additional purchases and sales that otherwise would not be there if options were not present. So in the absence of significant news, you will, in many cases, see the stock’s price get pinned to the strike price closest to the stock’s price.
Now let’s tackle the bigger, more important question: Why is pin risk a concern for retail traders?
The main reason it poses a risk is for those traders who have short options, whether calls or puts. It leaves traders with a big cloud of uncertainty as to whether they will be assigned or not. Going back to our example, if ABC stock is exactly $50 and you are short the $50 call or put, are you going to get assigned? Theoretically, you will not since there is no advantage in using the at-the-money call or put. However, news can break out after the market is closed and many brokerage firms allow traders to exercise after the market closes.

For instance, for those of you using Think or Swim, you can submit exercise instructions up to 20 minutes after the market closes. So just because an option may be slightly out-of-the-money going into the close does not mean the market will perceive it that way 20 minutes later. It depends on any breaking news that may occur during that 20-minute In fact, many corporations intentionally withhold big news until after market close so that it doesn’t create disruptions during market hours. It gives investors time to digest and think about the news before the opening bell. The point is that it is not uncommon to see breaking news hit the wires shortly after the closing bell.
So going back to the risks, option traders who are short options where the stock price is exactly the same as their strike, it poses uncertainty about assignment. Will they end up long or short shares of stock? They will not know until Monday morning. And during that long wait, a lot of adverse news can occur over the weekend.
The risk is that it leaves the trader with two very big outcomes based on very small stock price changes. For instance, if the stock price is $50 at the closing bell then the option may go unexercised. Of course, it is always the long call’s decision whether to exercise or not so one can never be 100% certain. However, if the stock’s price rises -- even just by a penny – then the trader will most likely get assigned and will end up short 100 shares of stock for each call he was short. This is true whether you have the shares in your account or not. Part of the margin agreement you signed to trade options states that you must have a margin account. And part of the reason is to handle situations like pin risk. If you do not own the shares to sell, the broker will create a short stock position in your account – and there’s no telling at what price that stock may open on Monday morning.
What can you do to manage pin risk? The easiest way to deal with pin risk is to close out any short options at expiration. For those of you using Think or Swim, they charge 5-cents and no commissions to do so. They do it as a service for their traders so it doesn’t look like they are advising to close short at-the-money (or even out-of-the-money) options in order to generate commissions. They advise it because it is the best way to handle the risk. If you close your short options at expiration, the uncertainty about assignment is eliminated. You know you cannot be assigned for any reason. Anytime you can remove that much uncertainty in the options market for 5 cents, it’s well worth it.
It’s interesting to note that if option traders closed short options, it will “undo” the effects of pinning. After all, it is the opposite of closing a long position so it has the opposite effects. This shows that the reason pin risk tends to exist is because retail traders typically do not close out short options in an effort to save a few cents.
Another point to understand about pin risk is that it only applies to equity options where you are taking delivery of the actual shares of stock, which is called physical delivery. On the other hand, if you are trading index options which are cash settled, there is no pin risk since the value of cash cannot move adversely. It is only when you are assigned on equity options and end up with unwanted long or short stock positions that you incur pin risk.
Pin risk presents a big problem for many option strategies such as butterfly spreads and short straddles. For these strategies, the trader wants the stock price to close at exactly the short strike to obtain maximum profit. However, in doing so, it maximizes the problem of pin risk. And I certainly understand the dilemma. Perhaps you bought a butterfly spread for $2 and the stock is getting pinned at the center strikes at expiration, which is exactly what you want it to do. However, to close the short option may cost 30 or 40 cents each due to volatility and bid-ask spreads. Why spend that kind of money which will greatly dampen your returns? If you ever find yourself asking that question, hopefully the answer will now ring clear – pin risk. I can tell you from years of experience with active trader option teams that your best solution is to close out the short positions. I hope this podcast will convince you too. And if it does, you have just become a little better at the art and science of options trading.
Options trading and investing can be very rewarding but you must understand all of the fundamentals in order to master the art and science of options trading. For those who would like to advance their knowledge, you may wish to consider the Alpha Trader Certificate Course and Strategy Lab.
Knowledge is a risk-free investment and understanding pin risk can only make you better at the art and science of options trading.