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Narrator: Experienced option traders know plenty about the risks that can leave them exposed. But you may be less familiar with pin risk, which could leave you with big losses after expiration. This is particularly relevant to multi-leg options strategies that have the same expiration date, such as vertical spreads, butterfly spreads, short straddles, and iron condors. I'll show you what I mean using an especially vulnerable strategy, the iron condor.
But first, let's talk 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 expiration day if the option is assigned. This is pin risk. The short side of the spread may be out of the money at close on expiration day, but if there is market movement after the bell that places it in the money, the long option holder could exercise, so you still might be assigned. You'd have to wait until the next trading day to find out, and there's a possibility the stock could open at a significantly different price than where it closed on expiration day. 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. Keep in mind, Charles Schwab may close your options positions to mitigate pin risk and other risks, if necessary.
On-screen disclosure: Commissions, taxes and transaction costs are not included in this discussion, but can affect final outcome 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 theoretical 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. And because the iron condor has two vertical spreads, it's particularly exposed. 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, or any options trade, 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 ZYX stock for a $150 net credit. 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 iron condor.
Now, let's imagine that at expiration, on a Friday for this example, ZYX 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 ZYX in your portfolio, you go into the weekend with two naked at-the-money calls. You're obligated to sell 100 shares of ZYX 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 ZYX 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 per contract, minus commissions and fees.
However, it's also possible that big news from ZYX 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 ZYX to open Monday at $80. If you fulfill your obligation right away at $80, you'd be set to lose $1,000 per contract, plus commissions and fees. That's nearly three times the max loss you planned for initially.
Some might try to mitigate the weekend or overnight market exposure by buying shares in the aftermarket. However, because it's possible for only part of your position to be assigned the next 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 ZYX, pre-expiration.
Instead of pinning at 70, let's say ZYX 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 contract: $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 ZYX will move over the weekend.
Let's say that ZYX 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 contract: $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 the stock will move in your favor over the weekend.
Regardless of the outcome, the same uncertainty exists. From the close on expiration day until the open on the next trading day, 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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