We’re headed into the home stretch of my blog series on early exercise. To date, we’d defined early exercise and established that it does, in fact, happen often enough to plan for. We’ve reviewed some factors that might up the chances of early exercise and assignment on your shorts; we’ve also calculated cost-to-carry and chatted about synthetic relationships that often drive the option owners’ decision to exercise (or not). Last week we focused on assignment risk to spreads, especially calendar spreads. And this week we wrap up with a discussion of what’s known as “pin risk”.
What’s pin risk?
Pin risk strikes short options traders right around the last moment of trading on expiration Friday. In short, it’s the unknown risk of being assigned when the stock trades right at or near your short strike.
I’ve said this several times before in this series, but it bears repeating now: when you’re short an option, you are not the one in control – the option buyer is. That means you may be called upon at any time to fulfill your obligation. Another theme of this series: there’s another human being on the other side of your trade, making decisions about whether or not to exercise an option. Sometimes they’ll make rational decisions, but sometimes they won’t. Even if exercising earns that investor the stupid award in your book, if you’re short you have to roll with their decision and how it affects your portfolio. End of story.
That said, the risk of early exercise becomes more real as expiration approaches and the underlying prices gets closer and closer to the strike. Will it finish ITM or OTM? That’s really the question.
There’s a common fallacy many options investors fall into that relates to the Options Clearing Corporation’s (OCC) “exercise by exception” policy. In a nutshell, under this policy the OCC will automatically exercise any expiring equity call or put in a customer’s account that is $0.05 or more in-the-money. In other words, the OCC has to develop provisions for the automatic exercise of certain in-the-money options at expiration, simply because many options traders fall asleep on expiration Friday. The policy does NOT imply that options HAVE TO BE $0.05 in-the-money before they will be assigned.
So, most options that are $0.01 cent in-the-money on expiration Friday will be exercised, and some that are exactly at-the-money or even a few cents out-of-the money get exercised. Why? On option expiration Friday after the markets are closed, you may have up to a half hour after the official market close to invoke your right to exercise your option. (How long you have exactly depends on your brokerage firm’s rules.) The after-hours markets for stocks may affect your underlying’s price - and therefore influence the option owner’s decision to exercise in the aftermarket.
This little fact is useful for both options buyers and sellers to keep in mind. If you’re an option buyer or owner, you could be leaving money on the table if news comes out in the aftermarket that moves the underlying’s price in the direction of your strike price. If you’re short the option, it’s even more important that you understand this scenario, because you’re not in control. The fact that the underlying stock closed below your strike on expiration Friday does NOT guarantee you won’t be assigned after the market is closed. It’s especially hard to know what will happen if the stock finishes right at the strike (say, if your strike price is 50 and the stock closes regular trading at 50). This is called being “pinned” at the strike.
But, as always in the markets, theory only takes you so far before the realities of practice suggest a more nuanced picture. If after-market news comes out that makes its prospects look weak going into the weekend, it’s not impossible to see puts that are even one or two pennies out-of-the-money (OTM) get assigned. If you’re short on the receiving end of such an assignment, it can come as a very nasty surprise. Here’s the problem: if you get assigned, under these circumstances, now you’re either long (if short put) or short (if short call) stock over the weekend, with no idea where the stock might open on Monday morning.
You got pinned. Now what?
Many traders first realize they’ve been pinned when an “accidental” long or short stock position shows up in their account on the weekend after expiration. If you’re suddenly and unexpectedly holding a position in a fast-moving stock like GOOG, for example, where that stock opens come Monday morning can come as a big surprise.
So what do you do? Start by considering your outlook for both the market and the underlying; what you decide may also depend on the capital in your account. Does the position you’re now holding reflect your market view or not? If you like the position’s outlook, do you have sufficient buying power to keep it without a costly margin call? For that matter, even if you DO have the buying power, make sure you’re comfortable with using it on this position. If you don’t have the capital, BUY IT BACK on the open of the market. It’s not worth the risk.
Like many other early exercise risks we’ve discussed in this series, there’s not really a magic book of answers (unfortunately). It’s much more effective to dodge the risk before it hits you than to react after the fact. Your best bet comes down to this: if you’re pinned, don’t panic. Just assess the situation as it now stands, make your best judgement, control any losses you may be facing as best you can – and learn what you can from the experience.
Often the smartest move at the close of short position to buy those short ATM options back for a nickel and sidestep the assignment risk entirely.
It sounds simple, but many traders don’t take this step, often because they just don’t realize pin risk can creep up and nail them with an assignment they don’t expect. The other reason many traders don’t close those Friday shorts is that, with volatile underlyings especially, volatility on the options can stay high enough on Friday that it becomes difficult to impossible to close your shorts for five cents. In short, some people won’t close simply out of an urge to be cheap. But believe me: closing them at a slight cost often works out MUCH better than getting stuck with a “surprise” position in a volatile stock over the weekend. What you saved in not closing can hit you as a much bigger cost that following Monday. Especially if you don’t have the funds to be long or short the resulting position.
If there’s one takeaway lesson to today’s post, it boils down to this: options can still be exercised after the markets close on expiration Friday, and whether you’re long or short the contract, that’s a fact you should consider in your trading plan.
Index Options
Many of these risks can be avoided if you trade index options. Most (not all) index options are European-style, which means they cannot be exercised early. What’s more, all index options are cash settled, which means if they’re in-the-money on expiration weekend only cash will change hands between the buyer and the seller. So only options that are in-the-money at least $0.01 will get exercised and assigned. Keep in mind: this is the case for indexes, not ETFs like the SPDRs (SPY) and DIAMONDs (DIA), which are tracking stocks for the S&P 500 index (SPX) and the Dow Jones Industrial Average (DJX) respectively. I plan on digging into index options more in this blog later.
Next time…
I’ve been fielding some questions lately about a phenomenon known as “volatility crunch”, so look for some posts on that topic coming very soon. I’m also warming up some posts on long calendar spreads, so look for those soon, too.
Hope you had a great Thanksgiving, everyone!
Regards,
Brian (OG)
[image: 6. Colorful or “Sharp as a tack” by Erica_Marshall on flickr]
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities.
