What is option pin risk?

Option markets are ‘pinned’ when the underlying product expires at or close to a strike price of one of the options. For example, suppose options are listed on a bond with strikes every 0.50 points (eg. 99, 99.5, 100, 100.5, 101 etc). At the expiration of these options, we would say the market is ‘pinned’ if it was trading at 100.00, 100.01 or perhaps 99.98. This is primarily a risk for traders who are short either calls or puts of the pinned strike. The reason it is a risk is that the trader who is short the strike, does not know for certain whether or not he will be assigned on options and therefore become either long or short the underlying.

Let’s consider an example. Suppose I am short the 100 strike put options. Suppose at expiration, the underlying is trading at 100.01. Now, in theory these options are out-of-the-money and should not therefore be exercised, because they are worthless. After all, the owner of the options could sell the underlying at 100.01, which is one cent better than exercising the puts and thereby selling the underlying at 100.00. But, things are not always that clear cut. Suppose that the Exchange rules that govern the expiration say that traders have 15 minutes to decide whether not to exercise their long options after the official expiration has passed. An arrangement like this is not uncommon because some time has to be allowed for traders to manually exercise their options via their broker or back office. Now suppose that during that 15 minutes, although the underlying product has also closed, another product that is still open and whose price is highly correlated with the underlying product, drops sharply in price. Now the owner of the out-of-the-money puts may think the puts are worth exercising because he estimates the underlying product has a chance of opening in the following session below the strike price. In other words, although the option have expired (technically) out-of-the-money, the trader may think there are reasons to believe that they are still worth expiring.

The problem for the short player here is that he has no control over whether he is assigned or not. Because the situation is not so clear-cut, he may still be assigned on the options he is short even though they were marginally out-of-the-money. The result is that the trader cannot be certain of his delta exposure.

What is so bad about pin risk?

Pin risk can be a serious risk for an options trader because ultimately it involves potential delta risk, which is always the most immediate risk an option trader faces. Option market makers for example will typically look to remain delta neutral, meaning they have no direct exposure to changes in the price of the underlying product. Pin risk can be a serious threat to delta neutral traders. Suppose an option trader is long the 100 strike calls and short the 100 strike puts and has everything fully delta-hedged (i.e. he is short the underlying in the correct proportion). This position is often known as a conversion. Most option traders will recognise this as a virtually risk-free position in many ways. The conversion has little or no Greek risk in many cases. However this position is highly exposed to pin risk.  The risk is that the market will pin on the 100 strike at expiration. If that happens, the trader does not know whether he will be assigned on the 100 puts and so cannot be sure what delta hedge is appropriate. If he is unlucky, he could find that following expiration he has a large delta position to contend with. The risk from this delta position can greatly exceed the profit that was made in creating the conversion position. So the pin risk affects the risk/reward profile of the trader’s position.

Strategies for dealing with and trading out of pin risk

Before expiration

In the days or even weeks leading up to expiration,  the option trader may start to consider strikes where pinning would potentially be a risk for him. Before this, an option trader is more likely to be looking at his net position (long calls plus long puts minus short calls and short puts) per strike, where put-call parity holds. One strategy for reducing pin risk is to actively aim to trade the correct legs of spreads. Suppose a trader has a risk reversal that is now in-the-money; the trader may now be viewing this position from a volatility-trading standpoint as a call spread. Now if he decides to trades out of the position, it would be normal to quote this position as a call spread, rather than as an in-the-money risk reversal. This is because most options are quoted as out-of-the-money positions rather than in-the-money; everything above the spot is considered a call and below it, a put. However, although the trader asks for a quote request in the call spread, he may then ask to trade the equivalent risk reversal, to ensure he is taking off his position precisely and not creating possible pin risk.

e.g. Trader buys the “99 / 104 risk reversal” (buys the 99 puts, sells the 104 calls). He delta hedges.

The spot falls to 96. The trader wants to take off the position.

Normally, the “99/104 call spread” would be expected to be quoted rather than the “99/104 in-the-money risk reversal”.

The trader may then show a bid for the call spread, but say he would like to trade the equivalent volatility level in the 99/104 risk reversal.

Trading conversions or boxes

A trader can trade out of the short position using conversions or boxes. A conversion is a delta-neutral combination of call and put of the same strike with the underlying. Trading a conversion can eliminate the trader’s short position.

A box is a long call-short put of one strike traded against a short call-long put of another strike. A box has a zero delta. Trading boxes can be an efficient way to eliminate pin risk from two strikes at once, if a trader can be found with the opposite position to oneself.

Conversions are technically very low risk (practically zero risk) structures leading up to expiry with the exception of pin risk. So paying to trade a conversion can feel like throwing money away. The trader has to balance this cost against the possible loss from being pinned. Effectively, this is an insurance game. Paying to remove pin risk is akin to taking out insurance against a loss due to pin risk.

Another alternative is to look to ‘leg’ conversions. When the cost of trading a conversion is considered prohibitive, the trader may attempt to trade out of the conversion ‘on legs’. This means perhaps trading out of the calls first, delta hedging and then trading out of the puts. This method really amounts to either taking one’s chances on the price of volatility or on the price of the underlying. Imagine a long call/short put/short underlying conversion position that the trader feels is a considerable pin risk. He could ‘leg out’ of this position by selling the calls (without delta), hoping the spot falls in price (making a profit) and then buy back the underlying and the puts. The risk here is obvious; the trader is just swapping pin risk for delta risk. Some traders may prefer this. This is a judgement call for each trader to make. Another strategy is to sell the calls and buy some of the deltas back ie. to sell the calls as a volatility play. The hope then is that either implied volatility falls or the options erode due to time decay and the trader can then buy back the puts and the rest of the short deltas.

After expiration

Sometimes a market is pinned and a trader who is short the pinned strike faces the risk of being assigned on some or all of his options. In such cases, the trader still has some choices about how to respond:

* Do nothing. The trader may think that the owner of the options will decide not to exercise at- or slightly out-of-the-money options and so he will not end up with an expected delta position. Or he may view being assigned as a 50:50 chance of being a profitable or loss-making scenario and be happy enough to assume that position in the very short term.

* Expect to be partially assigned. Some traders will assign a likelihood or expectation to their being assigned. If the trader is short 100 lot of the pinned strike, he may expect to be assigned on 50% of these options. So he may trade deltas in order to hedge this expectation.

Pin risk : the bottom line

* Pin risk relates to the risk that at- or even out-of-the-money will actually be exercised, unexpectedly, leaving the short option trader with an unwelcome exposure to the underlying product.

* Pin risk can be avoided by trading conversions/boxes or legging out of strikes/positions that could represent a pinning risk, before expiration.

* If a market is pinned at expiration, the trader needs to consider how to deal with the possible underlying exposure that he may (or may not) be exposed to.

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