Tag Archives | exercising for the dividend

Exercising call options for the dividend

Some myths die hard.
Some never die.

Here’s a comment from a reader:

I read a few of your online articles about when call owners should exercise to capture the dividend. It sounds like it makes sense, but I can’t reconcile this information with other material I read online such as:

Person A:
“I find, if a covered call has even a penny less than the dividend being paid [in time premium], I can be assured of exercise.”

Person B:
“I recently shared with a friend my frustration over early covered call assignment at ex-div. I have been called out early several times. The most recent time was on CTL. I had a call over a month out that was assigned early. That nice dividend was gone.

My friend put me in touch with a Dow Jones Newswire reporter who is writing a Wall Street Journal article on call volume spikes at ex-div….and the guy on the short side of the call.

He asked me to post his info for anyone who would like to tell of their own experience and frustration.”

Person C:
“You sound like you want have your cake (the time premium) and eat it too (the dividend). I think you should accept it as a virtual certainty that you will be assigned when coming into x-date if the time premium remaining is less than the amount of the dividend. Why would you expect that the holder of the contract you sold (the buyer) not want the dividend for himself? Since that person is usually a market maker (with a very low cost of doing business, including cheap commissions and a low cost of margin capital) you will usually be assigned.

If you get to just before x-date and you think you will be assigned you can always enter a spread order to roll the option to one less likely of assignment.”

Person B:
“I’ve traded CC’s for a long time but new to trading for the dividend income.
The CTL option was over a month out so I really didn’t think much about early assignment. I won’t make that mistake again.”

Person D:
“For stocks with large dividends, a call-holder will often exercise the option in order to capture the dividend. This will be done when the option is in-the-money and the Intrinsic value plus the forthcoming dividend exceeds the time value of the call.”

Perhaps these call owners are being exercised, but not for the reasons they think and only Wolfinger is correct?
Thanks.
Tristan

Some people refuse to believe – despite the evidence

There are people on this planet who do not believe man has ever gone to the moon. There was a time when ‘everyone’ knew that the earth was flat – before discovering, and finally accepting, the truth.

The people you quote are wrong. And it is so easy to demonstrate that they are not only wrong (as anyone can honestly be), but they are stubborn and do not allow the facts to get in the way of their ideas. And you can prove this for yourself.

Person A is not telling the truth. I refuse to believe that he was assigned on a call option with 49 cents of time premium – when the dividend was 50 cents. In fact it doesn’t matter how big the dividend was. If assigned with that much time premium, it was a gift. It was free money. But person A does not understand how options work and discarded his gift.

He has probably never been assigned on an option with any time premium remaining, but this is impossible for me to prove. However, what I can do is prove that he is either the luckiest trader on the planet or just not telling the truth.

      :You can find real world scenarios, but I’ll make do with a fictional example.

      I used the calculator made available by the CBOE and ivolatility.com.

      Stock price: $53
      Expiration: April 15
      Dividend is $0.50
      Ex-dividend date: April 1, or 14 days prior to expiration
      Volatility = 35
      Value of March 50 call (on March 31, the day that the option must be exercised to collect the dividend): $3.27

      Note that the call has $0.27 of time premium remaining, and the delta is 84. Those numbers tell anyone that this call should NOT be exercised to capture the dividend. The downside risk is simply too great.

      When you exercise a call, you are buying stock and selling a call. That combination of trades is equivalent to selling a put – same strike and expiration date as the call exercised. And you sell it for zero, collecting the dividend as the only payment for that put.

Scenario

The former call owner now owns stock, will collect the $50 dividend, and has something he/she did not have before the exercise: considerable downside risk. The stock is $52.50 (when the stock opens unchanged, it is lower than the previous close by the amount of the dividend.

The former stockholder, who is rejoicing – not complaining as your sample traders do – finds that his/her position is gone. That trader has collected all the time premium in the call option (removing all downside risk), but did not collect the dividend.

Instead, your former stockholders are bemoaning bad luck. All they have to do is open the EQUIVALENT POSITION (to the one held before being assigned). They do that by selling the equivalent put option. [If you are not aware that being short the put is equivalent to owning a covered call position, read this]

What is the value of that put?

In this scenario, volatility is 35, the stock is $52.5 and there are 14 days remaining before that put option expires.

    The put is worth $0.62. In other words, the person who was denied the $50 dividend can probably collect $60 for the put. The trader is better off by $10. That is truly free money. And the best part of being assigned that early exercise notice is that it’s not necessary to take the risk. The trader can be happy to have lost the dividend but be out of a risky position. It a choice: Take the free $10, wait for a higher price for the put (risking loss of the sale if the stock rallies), or be safely out with a profit.

This is not a bad choice. This is not something about which to complain. The people who are crying over the lost dividend never understood options well enough to consider selling the put. In reality they do not understand well enough to be using real money to trade options. Feel free to tell any of them that I said so.

Tristan: This explanation is basic to understanding options and how they work. If you don’t completely understand, please, think about it carefully before submitting a follow-up question. Understand this concept, and you are on your way to being a trader.

Trader B

Some options should be exercised for he dividend, even when one or two months remain. They are low volatility stocks paying a substantial dividend. To prove to yourself that volatility matters, look at the above example using a volatility of 18 instead of 35. You will discover that it’s (almost) okay to exercise. And most people would, even though it is theoretically not quite safe enough.

Person C

There’s not much to say. He talks big, but is option ignorant. The market maker would always sell the put instead of exercising. Any time the MM can get more than $50 for that put, it’s free money – when the alternative is exercising.

He is correct that if assignment is not what you want, rolling is one way to avoid it. But in given scenario, you should want to be assigned. It’s exactly the same as being given a free put option. You may keep that put (hold no position) or sell it.

Trader D

He would have been ok, if he had stopped sooner. His first sentence is true. The second is gibberish.

Tristan: Wolfinger is not always right. Nor is everyone else always wrong. You merely quoted four people who know not of which they speak/write.

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Excercising a Call Option for the Dividend

I recently had an email conversation with an experienced option trader.  He's not a full-time trader, but has been using options for several years.  The point of mentioning this is to illustrate that anyone can have a blind spot that's difficult to resolve.

***

Hi Mark,

I've been buying ITM calls on several stocks – trying to capture upside, while limiting potential losses. Usually, I've done these 10% ITM, and typically trade 6-month options.

Eventually I may do it for nearer months, and roll more often, but I wanted to get going with positions I didn't have to watch so closely.

For investors, rather than traders, I prefer the 6-month options you are using.  In fact, I recently blogged on that idea.

 

I choose stocks that have little or no dividend, because the higher yielding stocks have less volatility, and presumably need less 'protection'. One stock that I've done this for is PG.  With a current yield of almost 3%, I'm questioning the wisdom of this choice.

 

PG has an upcoming dividend of $0.44, with an ex-dividend date this Apr21. [Obviously it's now after that ex-dividend date] My Oct $57.50 call is $6.10, with PG now at 63.00.

Can I expect the value of my call to drop by this $0.44 amount on Apr21, and the same amount on the Jul21 ex-date?  Am I leaving money on the table if I buy such an ITM call and don't exercise or sell before the first ex-date?

Assume you exercise the call. Look at the interest rate you must pay to carry stock (which may be almost zero if you have a large cash balance) from the day you would exercise – before ex-div date please – through expiration.  If the cost to own stock is greater than the dividend, then you obviously do not want to exercise. 

If you can exercise profitably by that standard, in return for collecting the dividend you gain substantial downside risk.  If you buy the Oct 57.5 put, you would own a position equivalent to your long call (long stock plus long put = long call).  If the cost to carry
plus the cost of the put is LESS than the dividend, then you should exercise
to earn that extra difference. [Don't ignore trading expenses]

The problem arises when you cannot buy that put at an appropriate price, and that's almost all the time. 

In general, a call is an exercise for the  dividend when two things obtain:  1) delta = 100.  That does not mean 99;  2) Time premium is zero.  That means you cannot sell the call and collect a price above the option's intrinsic value.  When the option bid is below parity (intrinsic value), there is no time premium remaining in the option.

If youmcan collect time premium, then it's more profitable to unload your call and NOT exercise. To prove that to yourself, check the price of the option when the stock opens for trading on ex-dividend day.  You will see that the time premium in the option is greater than the dividend. 

In other words, you are better off by NOT exercising. Remember, exercising gives you all the downside risk you rejected when buying the call in the first place.  If the put is not cheap enough to buy (eliminating the risk) then you do not want to exercise the call.

For a low yielding stock, I really don't care about the dividend. I'm not sure I want to do an ITM play if I'm squandering the equivalent of a 3% yield, as in this example.

You are not squandering anything.  This is a basic part of how options work.

If the option is not truly an exercise for the dividend, then you bought the option – at a premium that recognized the stock price would be lower – due to the dividend.  In other words, you got a 'bargain' on the call when you bought it.  If there were no dividend, the call would have been priced higher.

However, when the stock rallies, your call may move far enough in the money that it becomes an exercise for the dividend.  Please be aware that not every ITM option should be exercised. And that's especially true for 6-month options.  The Apr 57.5 call was probably a good option to exercise, but not an October call.

If your call should be exercised (by the criteria above) and you don't want to do that, just sell it.  Then buy a different call, if you want to maintain an investment in this company. Perhaps the Oct 60 call?

The conversation continued:

If I don't really leave money on the table by not exercising (actually, I'd just sell the option before ex-div date - I have no interest in the stock itself), I'd really prefer to let the option ride, and hope the stock goes up over time. I'm not interested in rapid trading and over-trading. 

Some options must be exercised or it is tossing money in the trash.  Use a calculator.  Calculate theoretical value day before ex-div and day after (lower price of stock by dividend amount).  If the option is WORTH LESS  the 2nd day, then it should be exercised or sold (prior to ex-date).   Replacing the call is a separate decision.


Right now, the Oct 57.5 PG call has a delta of .75, and at $6.10, has a time premium of $0.60, given the stock is now at $63.00. So, you seem to be saying that there is no point in exercising (or selling back the call) before the Apr21 ex-div date. Will the option drop in price to $5.56 on that date ($6.10 less $0.44)? I still need to wrap my head around that.

It will not decline in price.  If delta is 75, nothing should change.  The computer 'know' the stock will be lower (due to dividend) and that information is already factored into the option price.  Do as I suggested above.  Use a calculator. If you don't do that, you will not discover all you need to know.

And if it does drop in price, why do you think it would be $0.44?  The delta is not 100.  You are over-thinking this simple problem.

The conversation continued in another email

I'll follow PG ITM option prices, as PG goes ex-div next week. 
Below is
what Hoadley would say for my PG 57.5 call. I set the expiration for May. The graph's red line clearly predicts an increase in the call's value on the ex-date of apr21.

No, it does not.

Likewise for the yellow line, were the ex-date to be May 15. Why do you say this is wrong?

2010-04-21_1047_hoadley_div_2

I cannot tell you how disappointing it is – that you ask this question.  You have been trading options for too long not to understand this.

You are not thinking – you are just using an available graph to get a quick answer.  You are assuming the graph is answering your question – but it is ignoring your question and choosing which question to answer.  Thus, it gives the right answer to the wrong question.    Use the calculator to get the right
answer.  More on this below.


Let's look at it this way:

1) Have you ever seen a call increase in value – overnight – when the stock price is not higher and/or the implied volatility is not higher?

2) The question you are asking Mr. Hoadley's graph is:  If the stock price is unchanged on ex-div date, will the value of my call change?  Good question. 
However, the graph answers this question:  If the stock trades ex-dividend, and if the stock price rises by the amount of that dividend, does the value of my call change?



3) Take a close look at the graph. Specifically the data below the graph.  The stock price is 63.  The stock price is not 62.56.  That is the price at which the stock would open for trading on ex-dividend day.  It's at that price – down 44 cents, but really  'unchanged' – that the call value remains the same (except for a decline – if any – due to theta. 

The reason you see the call price go up is because this graph shows the stock rising 44 cents to 63


That's what I mean by just looking at the graph and assuming it's
useful.  That's why a calculator is better.  Using the calculator, you would set the stock
price to 62.56 and not make this mistake.

I truly hope this clarifies the situation.

677


Coming in the May issue of Expiring Monthly

The Trade Off: Risk-Reward vs. Probability of
Profit by Tyler Craig

Interview with Dr Brett Steenbarger by Mark Wolfinger

and much more.


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