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