Tag Archives | exercise for the dividend

Trading Traps for the Unwary II

Continuing yesterday’s horror stories, Tristan submitted another:

Something doesn’t seem right about this. I was short the 115-116 call spread in SPY 55 times during March expiration. I was assigned on the 115 call (the short part of my spread) on Thursday after the close (found out Friday morning). This resulted in being short 5,500 shares on Friday morning versus my long 55 116 calls. On Saturday, I was debited from my account a significant charge because I was short the shares when SPY went ex-dividend on that Friday.

Am I responsible for the entire dividend payment for that quarter because I was short the stock on that one day of ex? Seems like stealing. I feel like if I had bought the stock that day, there is no way I would have gotten credit for an entire quarter of a dividend payment. Anyone know how this works?

***

“Anyone know how this works?” This is the stuff that drives me nuts. If you don’t know how it works, why are you trading a product where it is essential that you understand how it works?

Dividends are paid on specified dates. Whoever is short on that ex-dividend date pays the dividend. Whoever owns the shares collects. Very simple, very efficient and it has always been this way. It’s also fair and reasonable – for owners of the shares. When the stock (or ETF) pays a dividend, the stock price declines by that amount. Gain the dividend, lose in the share price. No one gains or loses.

Alas, it’s not so simple for option owners. When you own an ITM call option that should be exercised to collect the dividend – WARNING: NOT ALL ITM OPTIONS SHOULD BE EXERCISED FOR THE DIVIDEND – failure to exercise results in a real monetary loss. The trader who submitted the question above did not know about the dividend, did not know he should have exercised his calls, and donated his money to some lucky trader who had been short those SPY 116 calls.

To reply to the comment: You are correct. If you bought shares that day (Friday) you would NOT get any of the dividend. You would be too late by one day.

I do agree with the lamenter’s opening thought. There is something not ‘right’ about this situation. What’s wrong is that you should not yet be trading options because your education is far too incomplete.

More Questions from Tristan

For instance, what to do if long puts are automatically assigned upon expiration

If you know in advance that you cannot meet the margin requirement, then do not allow yourself to be assigned at expiration. BUY THEM BACK before expiration. There is no solution that’s any easier. If you are not short the options, then you cannot be assigned an exercise notice.

or if short legs are assigned in spreads

There is almost never any reason to be assigned earlier than expiration (other than exercising a call option to collect the dividend). However, this is a recurring problem for SPY options. It ALWAYS goes ex-dividend on the third Friday of the month. Not knowing that – in advance – is just a huge mistake. If you fear being assigned on any position, then the answer is very simple (Honest. This is a deadly serious situation) Answer: Get out of the trade. Do not hold to expiration. Ask yourself why would you decide to hold to the bitter end? It is so unnecessary. For goodness sake, get out when you may be assigned and especially when you cannot meet the margin call.

If you are assigned on one leg of a spread, and if margin is not a problem, keep the position. Someone handed you a gift, and if the stock makes a big move (down if you were assigned on a call option or up if you were assigned on a put option) then you will score a nice big payday. It’s unlikely, but it has happened before and will happen again.

However, if you are unable to hold the trade and must liquidate, do not decide to exercise your long option to get out of the position – unless this option has zero time premium. It is more efficient to buy back the short stock and sell your long calls [Or sell your long stock and sell your long puts].

as well as simpler topics such as bid/ask spreads, order types, conditional orders , orders I should place in advance . in case I temporarily go into a coma through expiration, the Pattern Day Trader classification, the same-day substitution rule, Regulation T, etc.

There is a lot of stuff on your list. The truth is that most people have no need to understand most items on the list. That raises the question that concerns you: Why are people allowed to trade when they don’t understand the rules? And how do you know what it that you must know when there is no one to provide a list.

The answer to the first question is easy. They are allowed to trade because it is profitable for the brokers. Nothing else matters.

There’s not much that the average trader can do about the items on your list. If he/she becomes a pattern day trader (not a common situation), that’s when he/she will learn about those trading limitations.

Most beginners have no need for conditional orders and have plenty of time to learn how to use them.

However, bid/ask spreads and limit orders are essential items. I assume that anyone who teaches options classes or writes books for beginners includes that information. Traders who jump right in with no education may have some painful experiences when entering market orders. Not everyone can be protected. Would you open an account and enter orders with no advance study or preparation? Of course not and there is no protection for those who do.

You have one advantage. You are aware that dangers exist, and although you may not ask every question, you will be frightened enough to ask questions about any situation that occurs to you. That may not be enough – but you would have to be very unlucky to not have discovered what you need to know when you aware that you don’t know what it is that you don’t know.

Some answers

Don’t pay the offer; don’t sell the bid.

Never never never use a market order. Limit orders only.

There is no need for fancy order types. Limit orders and stops (I don’t like stops for option traders) should be sufficient.

Buy back shorts when they get very cheap – just in case you do temporarily go into a coma through expiration.

The Pattern Day Trader classification is not a concern, unless you day trade. And if you do, you will soon learn the limits.

You can get much of this information from your broker. But get it in writing. The people in customer service may be as bad as your correspondent found them to be (yesterday)

The CBOE stories scare the living daylights out of me — I wonder what these traders were supposed to have read to understand/avoid those problems in the first place. It is not asking too much to know when a stock/ETF you are trading goes ex-dividend.

It really seems like trading was designed for people who have a Series 7 broker’s license and know all these nuances.

I understand how you feel. The bottom line is that people are trading – and they intentionally did not bother to learn the rules. They make bad assumptions and get stuck with the bill. When you sell a call option, you must know that the owner is allowed to exercise at any time prior to expiration. It seems to be a natural question to ask – why would anyone exercise early? That’s when the trader would learn bout dividends.

You may be frightened, but it seems to me that you are taking care to learn about lurking dangers.

928

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Early Exercise: Call Options

I have not posted about the concept of early exercise for some time.
It's amazing to me how this idea gets out of the starting gate and simply will not go away.

Mark,

How would a trader like you decide to do early exercise? 

Say you bought calls when they were trading in the 1.0 -> 2.5 range, now underlying has risen so that calls trade bid-ask at 4.0 / 4.8 and there is strong possibility of it going higher. Also assume in another case that they trade in the 6.0 to 7.0 range.

What would make you wait for early exercise till Wednesday morning, Thursday morning, Friday morning of expiry week as a trader?

Assume you have cash to buy all contracts. The time value is negligible, and theta is eroding it fast.

Would you change your mind if the risk-free interest rate was say 8% and not 0-1% as currently?  Is that rate a huge factor for 2-4 days anyway?

I read some books where a bunch of math experts say that except for a dividend-paying underlying, early exercise is impossible.

Personally, if I were the call buyer and I had bazillion money, I would not sell the calls as the bid/ask spread widens and the market makers play games. I would choose early exercise sometime on late Wednesday or anytime Thursday to remove option spread slippage, so I buy underlying at the strike price and immediately sell it to lock in profit, because underlying spread is narrower than the option spread.

Very interested in your reply.

Thanks

Amit,

***

This is a very easy question.

1) I WOULD NEVER, exercise a call option prior to expiration – UNLESS it is to capture a dividend.

Before I go further, there are three valid reasons why someone may want to exercise a call option early.  My guess is that >99% of all option traders will never encounter these situations. 

If there is a dividend, sometimes a call owner must exercise the option or it is throwing money into the trash.  The call must be ITM, the delta must be 100 and the option should not be trading over parity. 

A professional trader (market maker) may prefer to sell stock short to hedge some trades.  If he/she does not own long stock, then when expiration is near,  deep ITM calls can be exercised and the long stock immediately sold. That is not as good as selling short stock, but must suffice when there are no better alternatives.

When expiration is near and the call option is deep ITM, sometimes the option bid is below parity.  In that situation – and it is not that common because most traders do not hold onto options that move deep into the money – then it's often better to exercise and immediately sell stock than it is to sell the call. 

Selling the call is preferable because it saves commission dollars.  But if the bid is too low, then the trader may have to exercise.

These situations exist, and I mention them for the purist.  However, my contention remains that if you are a retail investor, you can easily go your entire lifetime and never exercise a call option – or have any reason to do so.


A smart retail trader NEVER exercises a call option.  What can be gained?  Think about it.  Why would anyone prefer to own stock and suddenly have downside risk.

If you are assigned an exercise notice on a call option prior to expiration, consider it to be a gift (unless you cannot meet the margin call).

2) If I no longer want to own the option, I sell it.  You seem to arbitrarily hold options until Wed/Thur of expiration week.  That is terribly foolish.  The ideal time to sell an option is when YOU no longer want to own it – not on an arbitrary calendar date.

3) The price paid for the option is 100% irrelevant.  I don't know why so many people get hung up on this.  Assume you own a call option and the price is $6.  Assume you no longer believe the stock is moving higher.  Does the price paid for that option change the decision to sell?  Would you sell if the cost were $2 but hold if you paid $7?  If 'yes,' then you don't understand trading. 

When you no longer want to own a position then don't own it.  Do not hold just because it would result in a loss if you were to sell.  You already lost the money, and holding invites a larger loss.

Bottom line: You either want to exercise your option, or you don't.  You either want to sell your option, or you don't.  The price you paid is ancient history and 100% immaterial.

4) If the time value is negligible, then there is no theta to be 'eroding fast.'  Theta is the erosion of time value.

5) I would never change my mind.  Period.  Exercising a call option is stupid (exceptions noted above).  Just take that as gospel.  It is stupid.  Just sell it when you don't want to own it.  Interest rates do not matter over a two-day period.  But why own stock for two days?  Don't exercise.

6) If the option bid is less than parity (i.e. if you cannot get at least a fair price for the option), then it is possible to exercise and IMMEDIATELY sell stock.  But this involves extra commissions and is probably still a bad idea.

It is NOT the bid/ask spread that matters.  If the stock is 60 bid, you can sell stock at 60.  If you own the 50-call and the market is 10 bid 14 asked, what difference does that make to you if the market is wide.  If you can sell at 10, that is easier and less expensive than selling stock.

If however, the market is 9.90 to 10.10, that's a nice tight market, but does you no good.  You want to sell the call at $10.  So yes, in this example, you may exercise and immediately sell stock.

Exercising calls to own the shares is a trade made by someone who should not be trading options.  One more point – if you were to make the mistake of exercising early, why would you do it in the morning?  Wait until the close of trading.  It is possible that the stock will decline 20 points that day and you would be left holding the bag.  Exercise instructions are irrevocable.

Amit,

I have a problem when responding to question such as these.  If you have been trading for a two years, then none of this should be unknown.  On the other hand, if you have been trading two months, then it is reasonable for you to have not yet considered these ideas. 

When replying, I do not know to whom I am addressing the answers.  It can be someone who just doesn't get it, or it can be to a very eager to learn beginner. 

743

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