As a quick review, most of the stock options traded with individual stocks as the underlying are so called American exercise, meaning they can be exercised into the underlying at the strike price at any time prior to the expiration date. Most cash settled index options and some custom designed flex options are European exercise, meaning they can only be exercised on expiration. For our purposes we will assume that stock options held by retail investors are American exercise. Last time we talked about how the dividend process works and who is entitled to receive the dividend. Briefly, shareholders of record on the settlement date are entitled to receive the dividend, meaning that the stock must be purchased or the option exercised on the day before the stock trades ex-dividend. A stock trading at $60 and paying a $.50 dividend will open on the ex date at $59.50x, and those who purchased the stock or exercised their options on the day prior will get a $.50 check per share. Stock purchased or those options exercised on the day prior to the ex date will settle by the settlement date. What happens to the holder of an in-the-money Call option? In a simple example, where the stock goes ex on Tuesday of expiration week, the holder of a non-exercised in-the-money Call option loses out on the dividend. Remember, the holder of the $60 stock loses $.50 on the stock when it opens at $59.50 on the ex date, but actually receives the $.50 payment from the company. A holder of, for example, the $50 strike Call option at $10 would have that option open at $9.50 the next day, but he or she does not receive the $.50. A holder of a deep in-the-money Call that does not exercise effectively "loses" the dividend and is out $.50 a share. Imagine if this were a foreign stock paying a $6 or $8 dividend. The solution therefore is to either sell the deep option or exercise on the day before the stock goes ex to avoid "losing" the dividend. This is a pretty extreme example. Not many $60 stocks pay a $.50 dividend, and those that do probably do not go ex on Tuesday of expiration week. How can you, or your broker or advisor, know when an option should be exercised early for the dividend? The formula is actually fairly simple, and I would hope your broker or advisor has at least heard of it. If the amount of the dividend minus the amount of the interest paid for the early stock purchase exceeds the price of the Put at the Call strike, the Call should be exercised. Whoa,
that is not simple!! Let's go slowly. In the above example, when we
exercise the $50 Call early we are in essence committing an additional
$50 to purchase the stock at our strike of $50. The further away from
expiration the greater this interest cost becomes. At 6% the interest
cost is roughly $.01 per day, so it will become a factor on longer-term
options. Of additional consideration is the increased risk in the
new position. The holder of the $10 Call options had exactly $10 risk
in his or her position, if the stock had a violent move below $50
the risk would be capped at $10. After exercising the option and purchasing
the stock, the risk has now increased to $60, the full price of the
stock. In order to make the positions equivalent it would be necessary
to purchase the 50-strike Put option, which would again limit the
downside risk after exercise to $10. This is not as difficult as it
sounds, as most investors realize that the total risk in a stock position
is greater than a corresponding option position, especially recently.
Again, this different risk profile becomes more of a factor the further
away from expiration the proposed early exercise becomes. |
||||||