A little known but large risk in options trading

Let’s talk today about a little covered aspect of Options trading called Pin risk. While all options trading carries inherent risk and should only be attempted after a great deal of education on the subject (preferably with a large amount of paper trading first to understand how trading options works without the risk), there is a misconception about some aspects of options trades that I would like to take the opportunity to shed some light on.

What I will be covering today additionally with pin risk is one of the easiest ways to find yourself on the bad side of pin risk and that is the credit spread. A simple primer is that a credit spread is a trade that can be used with puts or calls and is usually done in order to collect what is called a premium. A premium is the amount of money a trader collects for agreeing to take on a short position. A short position means one in which the trader does not own the underlying position they are agreeing to take on. Often traders will do this with positions that are outside the money or OTM meaning that the intrinsic or monetary value of the position does not require them to purchase it.

There are two main types of credit spreads one is called a bull put spread, where a put (short) is sold for a certain price and then a another put (bought) at a slightly lower price completes the trade. This is done to lower the inherent risk of being assigned the short position because instead of being liable for the entire amount of the 100 shares of stock as would be due if the call was a straight put, the person only owes the difference in dollars between their sold put and their bought put, because someone has agreed to pay that lower amount for your shares. This is considered a bullish bet because it counts on the stock staying above the short put strike price.

The opposite is the Bear Call spread. The bear call spread sells a call closer to the current price of the company and buys one slightly higher as their hedge (protection). This position counts on the companies trading price to go lower so neither call is in the money or at the money (ITM or ATM) which when a trader normally is assigned shares for the options they have taken.

Both of these styles of options are done with the options expiring on the same day. This is where the lesson for today begins. Conventional teaching of these systems is that when using these strategies the goal is have the contracts you agreed to buy and sell expire out of the money and therefore worthless. You keep the premium and often use it to fuel buying positions for your portfolio, or some use it as extra income each month. Whatever the reason people are engaging in them the goal is for the contracts to expire OTM. The contracts expire at the close of trading for the day, this is the conventional teaching.

However, there is a caveat to this that I have yet to find in any course on options trading, website of a brokerage or discussed in a forum where you can easily find it. What I have found was the need to google “pin risk” options to find information on it. What this states is that the person holding a short position at close of trading is not done. The person who sold the option to you has up to one hour after the close of trading to exercise their option, which means an extra hour you are liable for the position.

This also means if it is exercised that Friday (all options expire on the close of trading the Friday of their expiration), you will not know about it until at best Saturday or possible even Monday. The shares if exercised and assigned to you will show up in your account. You are now liable for the difference between the price you bought them at (your short position strike price) and where the price is then. This is important! The long position you took to protect yourself, or hedge the position as it is called, does not protect you in any way from this unless you are calling your broker in the hour after trading ceases and tell them to exercise it. This means a loss for you, but can be much less devastating than being liable for the shares you own on Monday at market price.

Again, you will not know that you even have need to exercise your long option when you have to decide whether to execute it or not. This is called the pin risk. It is the risk that even though your option was worthless at the end of trading, if after hours prices fall (most likely) or the person who is long decides to take a loss (less likely but still possible if they are offsetting gains elsewhere) you may still be assigned the contracts and will have no idea until it is too late to do anything about it.

If this puts you in a negative position with your brokerage they will likely sell the positions as soon as they see them in pre-trading on the first trading day of that week no matter whether it is a positive for you or not. We know that pre and post market trading are strange animals which are moved by either news or opinions of the talking heads on CNBC, FOX or whatever news station you get your business updates from. It is often a wild and roller coasterish ride and you will have your positions sold wherever the person on the computer at your brokerage decides to sell at.

With that said, there is only one SURE way to avoid this risk (several other options are availabe like rollouts, but I am not prepared to go into that subject here and now and they still carry a risk element to them), because remember being in the money or at the money are almost certain to land you shares while being out of the money does not mean anything in reality, is to close your positions before the end of the trading day. That is to buy back your short positions and sell your long positions. This can cost you more money than you made taking the agreement on initially or it could leave you with a profit smaller than if you let the contract expire and gamble that you will not be assigned the positions.

Again, closing out your positions before the market closes for the day is the only SURE way not to be assigned, because the contracts no longer belong to you in any form at that point. Remember that any time your positions move into the money or are at the money prior to the close you are also at risk, so plan accordingly.

The last part of this covers the subject in regards to margin trading. If you are leveraged (using the equity in your account and money available to you in a margin loan) to up the amount of contracts you can buy and sell to make more money it can bite you. The brokerage doesn’t care themselves about the fact that when they sell the shares assigned to you it may be more money than you have. They have risk departments that try to get rid of the shares as quickly as possible at the best price they think they can get. Often you may not even have the opportunity to try and handle the problem yourself and limit damage. They will do what they consider in the best interest of the brokerage and you will still owe the money.

This is something again that I have not seen taught and presents a very real risk when a reasonably confident person who has not encountered this little known sticking point believes that their hedge covers them and their option expiring worthless at the close of trading is the end of their worries if they are even a few cents or $100 out of the money. It can present them a nasty surprise the next morning when the system assigns them and there is nothing they can do about it.

So close your trades or roll them out or whatever you need to do, don’t gamble on human nature or what the notoriously fickle market will do or learn after hours and then that somehow you will have a hand in the resolution of the situation. There is a lot of room for great gains in options trades, but there are also some very significant opportunities for loss that might not be outlined where you can easily find them or that you can even conceive of. Don’t get bit, take the hit.

See y’all around.

-Daddicus Rex

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