Options trading offers traders many potential benefits, including managing and limiting risk. Among these is pin risk, a common form of directional exposure that comes with options trading that can result in losses if not managed properly.
In this article, we’ll explore what pin risk is, how it operates in various situations related to options trading, and strategies one can implement to minimise exposure to this type of directional exposure. By understanding how pin risk works and proactively managing it through trades or hedges where possible, traders can maximise the probability of achieving their desired results from options trading.
What is pin risk?
Pin risk is a directional exposure resulting from the tendency of options to become “pinned” near their strike prices at expiration. As expiration approaches, the intrinsic value of an option steadily declines as time passes, causing the price to move closer and closer to its strike price. It creates a situation where traders may only be able to fully benefit from the time value of their option position if the underlying security’s price moves past its strike price by a significant margin.
Pin risk can be experienced with any option, but it is most commonly seen with long call and extended put options. In both cases, the option holder has a directional view of the market, either long or short, and they are exposed to pin risk if their prediction does not come true before expiration. Saxo markets can provide a visual example of pin risk in a long call option.
What are the everyday situations in which pin risk can arise?
There are several common scenarios in which pin risk can potentially arise. The most common is when traders take a position in out-of-the-money options or near-the-money options with short time frames before expiration. In these cases, the option may need more time to move past its strike price, resulting in a loss.
Another situation in which pin risk can arise is when a trader holds a long call or put option with an intrinsic value greater than its time value. It may occur when the underlying security is trading close to the strike price, as the option’s intrinsic value will be eroded by time decay faster than its time value.
Finally, pin risk can also arise when a trader is short an option and the underlying security moves close to or past the strike price. In this case, the option may become “pinned” near its strike price, resulting in a loss for the option seller.
How can traders manage pin risk?
The first step to managing pin risk is to be aware of its existence and understand the scenarios in which it occurs. It will help traders identify situations where their exposure may be higher than expected and take steps to reduce or eliminate it.
One strategy for managing pin risk is to choose option strategies with longer expiration dates. With a more extended time before expiration, the option will have more opportunities to move past its strike price and benefit from its time value.
Another strategy is to trade in-the-money options when possible. These options have an intrinsic value more significant than their time value, which means they are less prone to being “pinned” near their strike prices.
Finally, traders may also consider using hedging strategies to limit their exposure. It can be accomplished by purchasing a put or call option in the opposite direction of the existing trade, which allows the trader to offset some of their directional risks.
What are the benefits of managing pin risk?
Managing pin risk can be beneficial for traders in several ways. The most obvious is that it can help protect a trader’s capital, as they will not experience significant losses due to their options being “pinned” near their strike prices.
In addition, managing pin risk can also help traders maximise their chances of succeeding in their options trades. By understanding the scenarios in which pin risk is most likely to occur, traders can choose strategies that are less prone to this type of exposure and increase the chances of making advantageous trades.
Finally, managing pin risk can help traders protect themselves from extreme market movements. As time passes, an option’s time value will erode, leaving the option with less potential for a significant move in either direction. It can help protect traders from unexpected market events that could cause their positions to become risky.
How can a trader avoid pin risk altogether?
Unfortunately, it is only possible to avoid pin risk partially. As with any market risk, traders need to be aware of the scenarios in which it may arise and take steps to reduce or manage their exposure accordingly.
However, a few strategies can help traders minimise their exposure to pin risk. These include trading options with longer expiration dates, trading in-the-money options when possible, and using hedging strategies to protect against extreme market movements. By implementing these strategies, traders can reduce their risk of being “pinned” near their strike prices and maximise the chances of making a good trade.
Ultimately, pin risk is an unavoidable part of trading options. By understanding how it works and taking steps to reduce or manage their exposure, traders can help protect their capital and maximise the probability of success in their trades.