Pin Risk
Conversions and reversals are relatively low-risk trades. Rho and early
exercise are relevant to market makers and other arbitrageurs, but they are
among the lowest-risk positions they are likely to trade. There is one
indirect risk of conversions and reversals that can be of great concern to
market makers around expiration: pin risk. Pin risk is the risk of not
knowing for certain whether an option will be assigned. To understand this
concept, let’s revisit the mind of a market maker.
Recall that market makers have two primary functions:
1. Buy the bid or sell the offer.
2. Manage risk.
When institutional or retail traders send option orders to an exchange
(through a broker), market makers are usually the ones with whom they
trade. Customers sell the bid; the market makers buy the bid. Customers
buy the offer; the market makers sell the offer. The first and arguably easier
function of market makers is accomplished whenever a marketable order is
sent to the exchange.
Managing risk can get a bit hairy. For example, once the market makers
buy April 40 calls, their first instinct is to hedge by selling stock to become
delta neutral. Market makers are almost always delta neutral, which
mitigates the direction risk. The next step is to mitigate theta, gamma, and
vega risk by selling options. The ideal options to sell are the same calls that
were bought—that is, get out of the trade. The next best thing is to sell the
April 40 puts and sell more stock. In this case, the market makers have
established a reversal and thereby have very little risk. If they can lock in
the reversal for a small profit, they have done their job.
What happens if the market makers still have the reversal in inventory at
expiration? If the stock is above the strike price—40, in this case—the puts
expire, the market makers exercise the calls, and the short stock is
consequently eliminated. The market makers are left with no position,
which is good. They’re delta neutral. If the stock is below 40, the calls
expire, the puts get assigned, and the short stock is consequently eliminated.
Again, no position. But what if the stock is exactly at $40? Should the calls