Considerations when Managing Risk. II

In Part I we discussed position size. Always remember that risk management begins right there.

Simple Decisions that lead to Trouble

Traders encounter situations in which they are called upon to make what appears to be a simple decision. Yet careless or less experienced traders often make decisions that increase risk – in return for a reward that is far to small to compensate for that risk.

Saving money on commissions

I believe that traders should pay as little in commissions and fees as possible. However, it is is essential not to sacrifice good customer service or quality trade executions. I also know that many traders have long-time associations with a broker and are not anxious to change.

If you like your broker and want to continue to give them your business, that’s an acceptable decision. However, it is vital to NEVER allow the cost of commissions to prevent the making of a risk-reducing trade.

It’s one thing to fail to enter into a new position because costs are too high. Trading costs must always be considered when taking a new position. However, when managing risk, potential losses are far larger than the small number of commission dollars saved by not trading, and it is important to be careful. Please do not take extra risk to save a few dollars.

Exercising a call for a dividend

Owners of in the money (ITM) call options frequently exercise their calls one day before the stock goes ex-dividend. Why? To own the stock in time to collect the dividend. Many times this is the correct, money-making thing to do.

However, far too many traders exercise those options at inappropriate times, thereby subjecting themselves to unnecessary, yet significant risk. The saddest part about this is that these traders remain unconvinced, and repeat the mistake – until they eventually discover the problem.

    The setup is easy to describe.

    There’s not a lot of time remaining before the option expires: Perhaps 2-3 weeks

    The call option is not in the money by very much, and has a delta of 80 to 85

    The dividend is very attractive, perhaps 1% of the stock price, and the call owner wants that dividend

    Thus, the call is exercised

    The result:

    • The call owner now owns 100 shares of stock, priced @ $62.50 when the call was exercised
    • The previous call owner, now a stockholder, is going to collect that $60 dividend at a later date
    • If the stock opens unchanged on ex-dividend day, that translates into a price of $61.90
    • The trader now faces significant downside risk, something he/she did not face as the owner of a call option

That morning, ex-dividend day, two things occur and our dividend-hungry investor is aware of neither.

First, the front-month call with the $60 strike is $2.65 bid. That means that any trader can buy stock, paying $61.90, and write that call, collecting $265. The time premium in that option is $75. Instead of collecting that $60 dividend, the trader could have remained long the call – and then – ex-dividend day – bought stock and sold the call. Instead of getting the $60 dividend, he could have received $75.

Second, the front month put with the same $60 strike is $0.70 bid. Instead of buying stock (via exercise) and selling the call (when you exercise an option, it no longer exists), our trader could have sold the put option, giving him/her the equivalent position [buy stock/sell call is equivalent to sell put] with the same downside risk. But this time he/she could have collected $70 instead of the dividend.

Don’t let this happen to you. Look at the option value before exercising. Look at the option delta. It is not right to exercise when the delta is less than 100. And it is not right to exercise when there is even one penny of time premium remaining in the price of the call option.

The idea is not to own stock when it is has a significant chance to dip below the strike price of the option exercised. When the delta is 100 and the option trades with no extrinsic value, that’s when the odds favor exercising for the dividend.

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