Monthly Archives: May 2012
Pin risk is a term that is understood by professional options traders, but generally not very well understood by the investing public. Covered call writing is the most basic of all option strategies and is widely used by many investors. It has been proven that covered call writing can reduce risk and enhance return in a portfolio. In today’s low interest rate environment, more and more investors are turning to covered call writing as a way to produce some needed income from a retirement account.
When a covered call is written there are two scenarios that can unfold at option expiration. One is that the underlying stock or ETF will be above the call option strike price and the stock will get called away. The other scenario is that the price of the underlying stock is below the strike price of the call option and the call option will expire worthless.
So, what happens if you are very close to option expiration and the underlying stock is right at the strike price? The answer is that you can’t be sure whether or not the stock will get called away. It’s not an issue if you don’t care whether the stock gets called or not. It can be a major problem if you want to get called and don’t. For example say you bought 100 shares of ABC at $45 and sold the $50 call for $1. The stock is over $50 on the last trading day prior to expiration and this is a situation where you want the shares called away from you. You either need the capital for another investment, or no longer want the stock in your portfolio due to deteriorating fundamentals or technical analysis. With 30 minutes to go on the Friday before expiration, the stock is at $50.05, it looks like you should get it called, but what happens if the stock settles right at $50 or moves below in the final seconds of trading? You may end up holding a stock that you wanted to get rid of. You could think that the stock was going to get called and find out on Monday morning that you still own it and that it has gapped down at the open creating a substantial loss.
The best way to eliminate pin risk is to close out positions on the last trading day before option expiration to be sure that you have the result you want. Buy back the calls for a few cents and sell the stock in the open market if you want it called away.
The same thing applies to any other short position, like puts, spreads, etc. Close the position if the underlying is very close to the option strike price near expiration if the unexpected option assignment or lack of an assignment will create problems for you.