Tag Archives | naked put selling

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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