Covered call writers know that early exercise is extremely rare. Call buyers are generally better off selling the option rather than exercising early. In this article we will evaluate why a call buyer may choose to exercise an in-the-money call option prior to expiration by evaluating the choices available to these option holders.
Value of a call option
Call value = intrinsic value + implied volatility + interest rate value – dividend value
Interest rate value factors in because of the benefit of spending less money for calls than actual shares and earning interest on the cash not spent. Dividend value factors in as a result of the dividend being received by the share holder and not the option buyer.
The key factors here are that the only potential negative impacting option value is the value of a dividend and the other three can never be less than zero. This means that if a stock does not generate a dividend, the options should never trade less than parity (intrinsic value only) and therefore should not be exercised early.
Hypothetical example
- BCI is trading at $50.00
- The $40.00 call expires in two weeks
- The stock goes ex-dividend tomorrow
- The dividend to be distributed is $1.00
- The theoretical value of the $40.00 call is $10.00 (trading at parity, all intrinsic value with no time value component)
- The call has a delta of 100 (1- same characteristics as the stock)
Available choices for the option holder
1- Hold the option
Assuming no other changes in investor demand for the security, the stock will lose $1.00 of value on the ex-date and open at $49.00. Since the option is trading at parity with a delta of 1, it’s value will be $9.00. In this instance, we are guaranteed a loss of $1.00 in this trade.
2- Exercising the option
If the holder exercises the option, shares will be purchased at $40.00 and the option holder then becomes a share owner. Because of the loss of the $10.00 option value, the shares are purchased, in reality, for $50.00 ($40.00 + $10.00 option premium). When the stock goes ex-dividend, the shares will drop in value to $49.00 but the former option holder, now share-owner, will capture that dividend. It is apparent that the exercise of the option is a better choice than holding onto the option.
3- Selling the option and buying the shares
If the option is, in fact, trading at parity ($10.00), this approach is exactly the same as early exercise because the option is replaced by the shares in both cases. However, if the option is trading above parity (has a time value component), say $10.25, this third choice would be the best. We are giving up our right to buy at $40.00, $10.00 below current market value, but receiving $10.25 in return. The loss in share price on the ex-date is compensated for by capturing the dividend.
Discussion
Early exercise of a call option is extremely rare and only makes sense when there is a dividend associated with the underlying security and the ex-dividend date comes prior to contract expiration. A trader may consider early exercise the day prior to the ex-date.
Ask Alan videos…WOW
My team continues to amaze me. Wait until you see the new graphics for future Ask Alan videos
Market tone
US markets rose to new highs on Thursday despite weak retail sales, industrial production and consumer sentiment. These stats may delay the Federal Reserve’s first rate hike.This week’s reports:
- According to the Job Openings and Labor Turnover Survey, or JOLTS, nearly 5 million jobs were open at the end of March, little changed from the 15-year high set in February.
- US employment increased by 3 million jobs in the 12 months through March, matching the annual job gains last seen in the late 1990s.
- Initial jobless claims fell slightly to 264,000. The four-week moving average now stands at 272,000, the lowest number since April, 2000
- April retail sales were unchanged from the prior month, below expectations of a 0.2% increase. Year-to-date, retail sales are up 1.9% from the same period last year
- The Producer Price Index (PPI) declined 0.4% in April, well below the expected 0.1% increase. Producer prices have declined in 5of the past 6 months and are down 1.3% from April 2014
- US industrial production was down 0.3% in April from the prior month, the fifth straight month of declines. The strong US dollar was a key factor holding back on the production of US exports
- The University of Michigan Index of Consumer Sentiment dropped 7.6% in April to 88.6 below estimates
For the week, the S&P 500 rose 0.3% for a year to date return of 3.1%.
Summary
IBD: Confirmed uptrend
GMI: 6/6- Buy signal since market close of May 11, 2015
BCI: Cautiously bullish favoring out-of-the money strikes 3-to-2. A bit more aggressive than the past few weeks.
Wishing you the best in investing,