Understanding Special Exercises and Pin Risk

In yesterday’s piece, I alluded to the concepts of special exercise considerations and pin risk for options holders upon expiration.  Understanding them is crucial for anyone who trades or invests with options, yet I have never fully explained those concepts.  Let’s rectify that oversight now.

If you are trading options, you need to be aware of special exercise considerations.  The Options Clearing Corporation (OCC) will automatically exercise an expiring option that is in the money by $0.01 or more.  For example, if you have an expiring call option with a $50 strike, and the stock closes at $50.01 or more, OCC will exercise it automatically.  A put option with the same terms would be automatically lapsed.  But there is an important feature that is not well-understood.  An options holder can offer contrary instructions.  The automatic exercise feature provides convenience to both the holder and the broker/dealer, but it does not remove any optionality from the holder.

It is crucial to remember that an options holder retains the right but not the obligation to buy or sell the underlying security until the option expires.  It is also crucial to remember that options expiration occurs well after the market closes (5:30 eastern for US options, 4:30 eastern for Canadian – see here for more).  What it means in theoretical terms is that there still may be some residual value to the option even though it is no longer tradeable.

If a stock or ETF moves up or down through a strike in the after-market, the option holder has the opportunity to offer contrary instructions.  That can include lapsing a long call on a stock that fell below the strike or exercising a long put in the same situation.  There are practical and potentially lucrative aspects to understanding this fact. 

One can endeavor to continue trading SPY, QQQ and a whole raft of other stocks and ETFs after 4:00 if they are near a strike and one holds long expiring puts or calls.  Realize that an option’s delta flips enormously as a stock trades around a strike on expiration.  Using the $50 call example, if the stock is at $49.99 on the close, the option is out of the money, with 0 delta and largely worthless.  If the stock were to flip to $50.01 in the aftermarket, the option is in the money with a 100 delta and worth at least a penny.  In something like QQQ, which can move a few cents in either direction after the close, that creates a trading opportunity.  Last Friday, QQQ closed at $342.01.  If I were long 10 puts, I would be seeking an opportunity to buy stock below $342.  If I bought 1000 shares at $341.92, I could then exercise my puts at $342 and lock in 8 extra cents on an option that would have expired worthless.  Or I could offer those shares somewhere above $342, hoping to make a profit on the stock and let the options lapse.  Ideally, QQQ would fluctuate around the strike, offering several opportunities to trade the up and downs in the shares while still owning protective puts that I could exercise at my choosing.

Sharp-eyed readers will notice that this creates a problem for whomever is short those puts or corresponding calls.  They may think that they will be avoiding an exercise, since the ETF closed above the strike.  But they could find themselves with a nasty surprise over the weekend if the holder chooses to exercise them.  Options traders refer to this as “pin risk”.  Someone who is short options near a strike at expiration is potentially exposed to unexpected assignment. That is why it is usually a very good risk management process to cover or roll options that are expiring imminently near a strike.  If you can cover an option for a few cents, presumably one that you sold for more money and avoid the risk of an unexpected assignment, it can be worth paying a few cents to avoid a larger unhedged risk later.  (See more about this topic here)

One peculiarity occurs if a stock closes exactly on a strike.  OCC will lapse all at-money options if the underlying stock closes exactly on the strike (aka “pin”).  In that situation, the holder would want to decide whether to provide affirmative instructions whether to exercise an expiring put or call.  If for no other reason than that, anyone trading options need to pay special attention to where their stocks are closing on expiration day.

By the way, I apologize if this all sounds confusing.  It’s not an inherently easy topic, which is why it is often overlooked.  On the plus side, if you’re new to options trading, consider yourself lucky.  That 1 cent exercise threshold that we mentioned in the second paragraph used to be 25 cents.  At least you no longer need to make affirmative special exercise decisions if your options closed 10 cents or more in the money.