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Exercising Call Options Prior to Expiration - Important Considerations


Overview:

Should I exercise my call option before they expire?

Exercising an equity call option prior to expiration ordinarily provides no economic benefit as:

  • It results in a forfeiture of any remaining option time value;
  • Requires a greater commitment of capital for the payment or financing of the stock delivery; and
  • May expose the option holder to greater risk of loss on the stock relative to the option premium.

Nonetheless, for account holders who have the capacity to meet an increased capital or borrowing requirement and potentially greater downside market risk, it can be economically beneficial to request early exercise of an American Style call option in order to capture an upcoming dividend.


BACKGROUND

As background, the owner of a call option is not entitled to receive a dividend on the underlying stock as this dividend only accrues to the holders of stock as of its dividend Record Date. All other things being equal, the price of the stock should decline by an amount equal to the dividend on the Ex-Dividend date. While option pricing theory suggests that the call price will reflect the discounted value of expected dividends paid throughout its duration, it may decline as well on the Ex-Dividend date.  The conditions which make this scenario most likely and the early exercise decision favorable are as follows:

1. The option is deep-in-the-money and has a delta of 100;

2. The option has little or no time value;

3. The dividend is relatively high and its Ex-Date precedes the option expiration date. 


EXAMPLES

To illustrate the impact of these conditions upon the early exercise decision, consider an account maintaining a long cash balance of $9,000 and a long call position in hypothetical stock “ABC” having a strike price of $90.00 and time to expiration of 10 days. ABC, currently trading at $100.00, has declared a dividend of $2.00 per share with tomorrow being the Ex-Dividend date. Also assume that the option price and stock price behave similarly and decline by the dividend amount on the Ex-Date.

Here, we will review the exercise decision with the intent of maintaining the 100 share delta position and maximizing total equity using two option price assumptions, one in which the option is selling at parity and another above parity. 



SCENARIO 1: Option Price At Parity - $10.00

In the case of an option trading at parity, early exercise will serve to maintain the position delta and avoid the loss of value in long option when the stock trades Ex-Dividend. preserve equity. Here the cash proceeds are applied in their entirety to buy the stock at the strike, the option premium is forfeited and the stock, net of dividend, and the dividend receivable are credited to the account.  This can also be accomplished with the same end result by selling the option prior to the Ex-Dividend date and purchasing the stock:

 SCENARIO 1

 Account Components

 Beginning Balance

 Early Exercise

 No Action

 Sell Option & Buy Stock

 Cash  $9,000  $0  $9,000  $0
 Option  $1,000  $0  $800  $0
 Stock  $0  $9,800  $0  $9,800
 Dividend Receivable  $0  $200  $0  $200
 Total Equity  $10,000  $10,000  $9,800  $10,000

 


SCENARIO 2: Option Price Above Parity - $11.00

In the case of an option trading above parity, early exercise to capture the discount, while preferable to inaction, may not be economically beneficial. In this scenario, early exercise would result in a loss of $100 in option time value and inaction a loss equal to the $200 dividend. Here, the preferable action would be to sell the option to capture the time value and buy the stock, thereby realizing the dividend.

 SCENARIO 2

 Account Components

 Beginning Balance

 Early Exercise

 No Action

 Sell Option & Buy Stock

 Cash  $9,000  $0  $9,000  $100
 Option  $1,100  $0  $900  $0
 Stock  $0  $9,800  $0  $9,800
 Dividend Receivable  $0  $200  $0  $200
 Total Equity  $10,100  $10,000  $9,900  $10,100

  

Please Note: 

Account holders holding a long call position as part of a spread should pay particular attention to the risks of not exercising the long leg given the likelihood of being assigned on the short leg.  Note that the assignment of a short call results in a short stock position and holders of short stock positions as of a dividend Record Date are obligated to pay the dividend to the lender of the shares. In addition, the clearinghouse processing cycle for exercise notices does not accommodate submission of exercise notices in response to assignment.

As example, consider a credit call (bear) spread on the SPDR S&P 500 ETF Trust (SPY) consisting of 100 short contracts in the March '13 $146 strike and 100 long contracts in the March '13 $147 strike.  On 3/14/13, with the SPY Trust declared a dividend of $0.69372 per share, payable 4/30/13 to shareholders of record as of 3/19/13. Given the 3 business day settlement time frame for U.S. stocks, one would have had to buy the stock or exercise the call no later than 3/14/13 in order receive the dividend, as the next day the stock began trading Ex-Dividend. 

 

Options Calander


On 3/14/13, with one trading day left prior to expiration, the two option contracts traded at parity, suggesting maximum risk of $100 per contract or $10,000 on the 100 contract position. However, the failure to exercise the long contract in order to capture the dividend and protect against the likely assignment on the short contracts by others seeking the dividend created an additional risk of $67.372 per contract or $6,737.20 on the position representing the dividend obligation were all short calls assigned.  As reflected on the table below, had the short option leg not been assigned, the maximum risk when the final contract settlement prices were determined on 3/15/13 would have remained at $100 per contract.


 Date  SPY Close  March '13 $146 Call  March '13 $147 Call
 March 14, 2013  $156.73  $10.73  $9.83
 March 15, 2013  $155.83    $9.73  $8.83

For information regarding how to submit an early exercise notice please see the PT website.

 

The above article is provided for information purposes only as is not intended as a recommendation, trading advice nor does it constitute a conclusion that early exercise will be successful or appropriate for all customers or trades. Account holders should consult with a tax specialist to determine what, if any, tax consequences may result from early exercise and should pay particular attention to the potential risks of substituting a long option position with a long stock position.

 
   

 

Account holders should refer to the Characteristics and Risks of Standardized Options disclosure document which is provided by Place Trade to every option eligible customer at the point of application and which clearly spells out the risks of assignment. This document is also available online at OCC's web site.

Delta: A measure of sensitivity which is derived from an option pricing model.  It measures how much an option's price will change for one unit of change in the underlying stock price. 



Special Options Notes

 

Pre-Approval for Options:  Customers wishing to engage in transactions involving option contracts must obtain pre-approval by a Place Trade Financial Registered Options Principal. Approval is based on your investment objectives, financial information and trading experience provided on your account application. For additional information, contact client services at 1-800-50-PLACE.

 

Trading Options in an IRA:

Options are offered in all IRA accounts including puts and calls, covered calls and married puts.



Margin Requirements for each type of Option Strategy:   

Interested in Trading Options on Margin? Learn about the Margin Requirements for each type of Option Strategy by Margin Combination.

 

If you maintain a minimum of US $100,000 (or USD equivalent) equity/Net Liquidation Value in your margin account you may qualify for a lower margin requirement and a waiver of inactivity fees.

 

Get a free copy of the OIC's Characteristics and Risks of Standardized Options to read prior to investing in options

 Download Characteristics and Risks of Standardized Options 

Options involve risk and are not suitable for all investors.  For more information; please read “Characteristics and Risks of Standardized Options” before investing in options.  For a free copy call 1-800-50-PLACE or 1-919-719-7200 or visit the OCC. There is no guarantee of execution. Orders will be routed to US options exchanges. 

Any trading symbols displayed are for illustrative purposes only and are not intended to portray a recommendation. 

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