Options Early Exercise
In the option world, the buyer of a call option has the right to buy stock for the strike price by before expiration date. When he decides he wants your stock at that price he will call his broker and exercise his right to force you to sell your stock to him at the strike price.
Options can be exercised by the option buyer at any time on or before their expiration date. The majority of options expire without being exercised at all. Of the ones that are exercised, almost all are exercised on their expiration date.
Sometimes an option is exercised before expiration, which is called early exercise. Early exercise sometimes happens if the underlying stock is about to pay a dividend (more on that in the ex-dividend section).
An example Of Early Exercise
For the illustration lets say you own 100 shares of EEM stock. It is trading at $46/share. You have sold an option in order to receive option premium. You had previously sold a call option with a 40 strike, and that option is currently trading for $6. It is trading at parity and there is no time premium left. . EEM will go ex-dividend tomorrow and they said they will pay $0.50 dividend.
Will the option holder do an early exercise on you today?
Yes, because tomorrow morning (the ex-div date) the stock will open lower by the amount of dividend paid ($0.50), and deep ITM options will be lower by that same amount. In order to avoid a loss equal to the amount of the dividend, most deep ITM options with no (or very little) time premium remaining will be exercised.
If the option had more than a few pennies of time premium remaining then the option would probably not be exercised. Depending on the bid-ask spread for the option holder, as well as his commission rates, he would probably be better off just selling his option rather than exercising it.
And this is probably obvious but if a stock does not pay a dividend (and therefore has no ex-dividend date) then the odds of early exercise are practically zero (because the person doing the early exercise is giving up any remaining time premium — he’d be better off just selling his option rather than exercising it).
Writing Covered Calls On Stocks About To Go Ex-Dividend
We sell options to collect option premium. Selling options is the same as shortening. Shorting a call option on a stock you own just before its ex-dividend date is a common income-oriented strategy. Assuming the covered call is not exercised, you will receive both the dividend income and the call option income. Let’s look at an example:
Example Dividend Capture With Covered Call
Example from Feb 22. The following day, Feb 23, is the ex-dividend date for CVI. The stock trades at 23.12 per share and the dividend is 50 cents. So, if we had bought 100 shares of CVI on Feb 22 and then sold a March 17 expiration, 25-strike call option (trading at 35 cents), we would have received both the 35 cents from the option and the 50 cents from the dividend. That’s 85 cents per share of income in about a month on a $23 stock. Here’s the math:
Buy 100 shares of stock: $23.12 per share = $2312
Sell 1 call option: March 17 expiration, 25-strike call option for 35 cents = $35 income
Tomorrow’s dividend of 50 cents = $50 income
Now, if we hold the stock until March 17 and if the stock is unchanged between now and then, we could sell the stock for $23.12 and our return would be:
Total income = $85
Total investment = $2312
Return = 85 / 2312 = 3.67% in 24 days, which is 56% annualized
In The Money vs Out Of The Money Covered Calls
In the previous example the strike price ($25) was above the stock price ($23.12), which is the very definition of an ‘out-of-the-money’ (OTM) covered call. While there is potential for some upside capital gain (the difference between the strike price and the stock price), there is also risk that the underlying stock will go down before expiration, thus reducing or eliminating the income generated.
A way to reduce that risk is to use ITM (in-the-money) strike prices instead of OTM strike prices. Instead of a 25-strike we could have used a 20-strike, for example. This removes any chance of a capital gain but it provides much more downside protection. Because, if the stock drops from 23.12 to 20 you will still make a profit from the dividend and the option premium. If the stock drops below 20 then you may have a loss, depending on how far the stock drops. Nothing is risk-free.
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