Question: Can someone please explain 'pin risk' for dummies?

I get the basic idea that if the spot price of the market closes very near to the exercise price of the options then the trader who wrote the options does not know how many will be assigned. Yet it is terms like 'naked short' and 'naked long' which are throwing me when the actual risk is being described. Also how dies it differ for put and call options.

Many many thanks

Answer:

naked merely means that you don't actually own the underlying stock that is backed by an option. You can buy an option for a stock you don't own but you have to be careful because if the option is exercised and you don't own the required amount then you have a problem (you'll loose money b/c you have to acquire the stock and sell it back at a lower price). In some types of markets naked investing is frowned upon. Its not a strategy an average person should invest in.

naked= you dont own the underlying
covered= you own the underlying
write= you sell the option to someone else

example of naked (random values assigned for the example)
I think McDonalds is going fall in price below the current $20 but i don't own any of the stock. I buy put options to strike at 20. If the price falls to $15 I can then sell that option to someone that actually wants to sell his stocks at 20 price instead of the current 15 and make close to a 25% profit. If the price went up i would just loose the small premium i paid for that contract. This is the gamblers option that doesn't want to put alot of liquid into a stock to make some money and roll the dice.


put and call is the type of contract.

put=sell rights
call=buy rights

for example,
if i write covered call on my 100 McDonalds stocks i am selling someone the right (up to the expiration date) to buy my 100 stocks at a set strike price and in return for that right (the option) i get a premium. I sold him an option on stock i own, therefore i write a covered call.

pin risk describes the risk you could be pin downed in or out of the money around expiring date. Sometimes traders may make a hasty decision a minute or two before the contract expires. If the price the moves the opposite way you can get "pined" into a situation where you may have to buy or sell it back (depending on the type of contract you have). Pin risk is more centered around brokers and option traders that own alot of options and trade them often. An average person that is buying a put option for simple hedging usually don't worry about pin risk.

<<<I get the basic idea that if the spot price of the market closes very near to the exercise price of the options then the trader who wrote the options does not know how many will be assigned.>>>

That is correct.

It is a big risk factor for people, such as market makers, who have large positions that will earn a small amount per contract. These positions, when combined, usually are "delta-neutral". (A delta-neutral position is one that neither increases or decreases in value when there is a small move in the price of the underlying security.)

For an example, let's look at a reversal (reverse conversion) spread using stock of XYZ company as the underlying security. The spread consists of:

Short 150,000 shares of XYZ stock at $108 per share,
Short 1,500 May puts with a strike price of $100 sold for $1.00 per share.
Long 1,500 May calls with a strike price of $100 purchased for $8.90 per share.

Total credit received per share when the spread is opened =
$108.00 + $1.00 - $8.90 = $100.10.

At expiration, the expectation is that 150,000 shares will be purchased (because the call options will be exercised if the stock is over $100 OR the put options will be exercised if the stock is below $100) for $100 per share, producing a profit of $0.10 per share = $15,000.

Pin risk is the risk that the price of the stock will be pinned at $100 at expiration. Because the puts are are a short position, there is no way to determine how many of the put options will be assigned at expiration. Only the holders (owners) of the put options decide how many to exercise.

The maximum risk is minimized by exercising 750 of the call options. That reduces the maximum size of the stock position after expiration to 75,000 shares. If all of the put options are exercised the resulting position will be short 75,000 shares; if none of the put options are exercised the resulting position will be long 75,000 shares. The stock position will be totally unhedged when the market opens the next trading day. (Any unhedged position is called a "naked" position.) Any change in the stock price in the wrong direction will create a loss on the naked stock position, quite possibly a loss far exceeding the $15,000 profit realized from the reversal.

-----

Obviously I am defining "naked" differently than the first answer you received. I am using the definition from Natenberg's "Options Volatility & Pricing" which is "Any long (short) market position with no offsetting short (long) market position".

A long stock position is naked if it is not offset by a short call position or a long put position.
A short stock position is naked if it is not offset by a long call position or a short put position.
A long call position is naked if it is not offset by a short stock position or a short call position.
A short call position is naked unless it is offset by a long stock position of a long call position.
A long put position is naked if it is not offset by a long stock position or a short put position.
A short put position is naked if it is not offset by a short stock position or a long put position.

There is some disagreement if a long call and a long put combination (or a short call and a short put combination) should be considered two naked positions. I tend to consider them two naked positions unless the strike price of the call option is lower than the strike price of the put option.