Monthly Archives: May 2012

Pin Risk at Option Expiration

Pin Risk

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.

Dynamic Delta Hedging

Dynamic Delta Hedging

Dynamic delta hedging is a term used for adjusting the delta of an option position due to price changes in the underlying security. One of the beauties and challenges of options trading is that there are so many different combinations to consider for any market outlook. Say you’re an income oriented investor and you have just established a delta neutral iron condor. In order to receive the maximum profit, you want the underlying security to stay between the two strikes and the entire position to expire worthless. As the stock or ETF begins to move your position will start taking on delta. The gamma of your position is the rate of change of the delta. If you were delta neutral when the position was initiated, check your gamma, the gamma is how much the delta will move with a one point move in the underlying. By knowing the gamma you can be prepared to make adjustments to your position to remain delta neutral. Complex positions that have a high positive theta will also have short gamma, meaning that you have to be prepared to adjust according to price movement in the underlying. In the case of a delta neutral iron condor, if the underlying makes an upward price move you have the choice of adding some long calls, more short puts or some long shares of the underlying stock. If it makes a downward move, you can add long puts, short calls or short some of the stock. Instead of just adding you can also look to reduce some contracts, so in the case of an upward move you’d want to buy back some of the short calls, or in the case of a downward move you could buy back some of the short puts, or you could consider any combination of the above.

One thing that you need to consider is how often you want to adjust, do want to check your position daily or several times during the trading day? Another consideration is how you choose to define delta neutral. Of course the strict definition is that delta neutral means zero deltas, however when it comes to trading you should establish a guideline so that you’ll allow some flexibility. It’s impossible to stay at exactly zero, so a good rule of thumb might be to say that you’ll allow a range of plus or minus 50 deltas. Allow the position to range from -50 deltas to +50 deltas and don’t make any adjustments until those levels are exceeded.

The final consideration is how to make the adjustments and that is where the fun comes in. Because there are so many different possibilities to evaluate for each position, it is wisest to use an expected return calculator and see which adjustments have the best mathematical expectancy. Remember if you want to add delta and want to add to the position you can buy stock, buy calls or sell puts. If you want to subtract delta and want to add to the position you can buy puts, sell calls or short stock. You can also adjust delta by closing out part of the existing position. Evaluating all of the possibilities is what makes options trading so flexible and challenging.