Definition
The term pin risk refers to a threat that an option held by the seller will expire at-the-money or near-the-money. Pin risk is a function of both the underlying asset's price as well as time.
Explanation
When an investor holds an option they are provided with the right, but not an obligation, to buy or sell the underlying asset at the strike price on or before the contract's expiration date. In the case of a call option, the holder has the right to buy the underlying asset, while a put option confers the right to sell the underlying.
When the underlying asset closes at-the-money or near-the-money, the holder of an option may decide to exercise their right and the writer could be assigned. For example, the holder of a call option may decide to purchase the securities or the writer of a put may decide to sell their securities. In the case of a call option, the holder may decide to exercise their right to purchase the underlying asset. If that occurs, the writer will be required to deliver the securities.
If the writer does not own all the underlying assets, they will be forced to purchase them at the start of the next trading day. If the price of the asset increases, the writer will need to purchase the underlying asset at a price that is even higher than the strike price on the option.
Example
An investor sells five put contracts for Company ABC with a strike price of $100.00 per share, which expires on Saturday. Friday is the last trading day before the contract expires and the price of Company ABC at the closing bell is $99.80, which means the contract is slightly in-the-money and the investor decides to exercise their right to sell the securities at $100.00.
This was a naked put, so the investor must purchase 500 shares on the open market on Monday so they can be sold for $100.00. Unfortunately, Company ABC opens at $101.00 on Monday, and the investor is forced to purchase 500 shares at $101.00 and sell them for $100.00.
Related Terms
liquid market, support, resistance, leg, breakout
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