Upbeat music plays throughout.
Narrator: If you have some experience trading options, you're most likely familiar with assignment risk. But you may be less familiar with pin risk. Not understanding these concepts completely can leave traders exposed to undefined risk. I'll show you what I mean using an iron condor. Because this trade has two vertical spreads, it's particularly vulnerable.
But first, let's recap pin risk.
When an underlying closes at, or very near, the strike price of an option, it's referred to as pinning.
If an underlying pins to a short option you've sold, you may not know on Friday if the option is assigned. This is pin risk. You'd have to wait until Monday to find out, and there's a possibility the stock could open Monday morning at a significantly different price than where it closed on Friday. If you're assigned, you'd then be required to buy (or sell) shares in the open market at a different price than you may have anticipated.
On-screen disclosure: Commissions, taxes, and transaction costs are not included in this discussion but can affect final outcomes and should be considered. Please contact a tax advisor for the tax implications involved in these strategies.
Narrator: Now let's look at how this could affect an iron condor.
One benefit of an iron condor is its defined risk. You know ahead of time what your potential max loss is.
The difference between the long and short strikes, or wingspan, minus the net credit received at the time the trade is placed is the maximum loss of the trade placed.
However, this is only true as long as both wings of the trade are open. This is where pin and assignment risk come in. We have to remember that there is no guarantee that the long and short legs will both expire, or be assigned, and exercised at the same time. With iron condors, you can't "set it and forget it."
If the underlying closes at expiration between the strike prices on one of your wings, or is pinned to one of the short options, the trade's risk profile will change.
Let's look at an example.
Say, you sold two 60-65-70-75 iron condors on XYZ stock for a $150 credit per spread. You'd calculate your max loss as $500 from the five-point difference between the long and short options strikes, minus the $150 credit. This is $350 per spread.
Now, let's imagine that at expiration, XYZ ends up pinned at 70. The long put, short put, and long call are out of the money and will likely expire worthless.
The short call will almost certainly be assigned.
Assuming you don't own 200 shares of XYZ in your portfolio, you go into the weekend with two naked at-the-money calls. You're obligated to sell 100 shares of XYZ at $70 for any contracts that may be assigned, but you don't know where the price will open on Monday or if you'll be assigned on both contracts, one contract, or neither.
While your potential profit increases if the stock price opens lower…you're also left with unlimited market exposure over the weekend. Here's what I mean.
If XYZ opens on Monday at $68, this might actually be good news. In addition to the $150 credit from the original trade, fulfilling the assignment in a timely manner could potentially make you $200, minus commissions and fees.
However, it's also possible that big news from XYZ could break over the weekend. Perhaps the company announces a groundbreaking invention, causing the stock to jump in after-hours and premarket trading.
Say this happens and leads XYZ to open Monday at $80. If you fulfill your obligation right away at $80, you'd be set to lose $1,000 per spread, plus commissions and fees. That's nearly three times the max loss you planned for initially.
Some might try to mitigate the weekend market exposure by buying shares in the aftermarket on Friday. However, because it's possible for only part of your position to be assigned on Monday morning, you might end up holding a stock position you don't want.
So you can see why it's important to monitor, and potentially close, your iron condor trade several days before expiration—to avoid undefined risk.
This dilemma doesn't only happen if a stock gets pinned. It can also occur any time the short option gets assigned.
Let's go back to our original iron condor on XYZ, pre-expiration.
Instead of pinning at 70, let's say XYZ closes at $72. Your short call is in the money and likely gets assigned.
Meanwhile, as in our previous example, the other three legs of the trade are likely to expire worthless.
You might calculate your loss as $50 per spread: $200 to settle the short call, minus the $150 credit.
However, even if you get assigned, you won't actually be able to fulfill the assignment until Monday morning. The same risk exists that XYZ will move over the weekend.
Let's say that XYZ announced that same groundbreaking invention, causing the price to jump over the weekend and open at $80.
If you buy at the open, your loss would jump to $850 per spread: $1,000 to buy the stock and sell it at a loss, minus the initial credit. Once again, your loss is greater—2.5 times to be exact—than what you initially calculated.
Of course, it's also possible that the stock will move in your favor over the weekend.
Regardless of the outcome, the same uncertainty exists. From the close Friday until the open Monday, you won't know how much you might gain or lose. This is an uncertainty that many traders don't like.
To avoid this type of pin and assignment risk, monitor your trades carefully and consider closing spreads a few days before expiration, especially if one of your short options is near, or in, the money.
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