The Dividend Play

Avoid Exercise Mistakes

Dividends
Exercising call options to collect a dividend. Google Images

Exercising call options for the dividend

Question from a reader:

I read your online articles about when call owners should exercise to capture the dividend. It makes sense, but I can’t reconcile this information with other statements that I read online, such as the following: 

Are these people all wrong while only you are correct? That seems unlikely.

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

Person B:
I am frustrated over receiving an early assignment on the ex-dividend date. This happened several times. Recently I had a call with more than one month to expiration, yet I was assigned early. That nice dividend was gone.

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 ex-date if the time premium remaining is less than the amount of the dividend. Why would you expect that the call owner to not want the dividend for himself? Every market maker would exercise.

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

My rebuttal to the above opinions:

Some people refuse to believe the truth -- despite the evidence or mathematical proof.

 There are people on this planet who believe man has never gone to the moon. There was a time when everyone 'knew' that the earth was flat. The point is that some people will continue to believe what they want to believe. 

The four people whom you quote are wrong. It is easy to demonstrate that they are both wrong and stubborn.

They do not allow facts to get in the way of their beliefs. Fortunately, you can prove this for yourself.

Person A is not telling the truth. He states that when an ITM option has (for example) residual time premium of $0.49 or less -- when the dividend is $0.50 -- that he is assured of being assigned an exercise notice on the day prior to ex-dividend date (i.e., he receives that notice on the morning that the stock goes ex-dividend).

If he is ever assigned with that much time premium in the option, it would be a gift. It would be free money. But person A does not understand how options work and therefore probably threw away his gift.

You can find real world scenarios, but I’ll make do with a made-up example.

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

  •    Stock price: $53
  •    Expiration: April 15
  •    Dividend $0.50
  •    Ex-dividend date: April 1, or 14 days prior to expiration
  •    Volatility = 35
  •    Value of March 50 call (on March 31) is $3.27. (Last date option can be exercised to collect dividend)
  •    Value of Mar 50 call on Apr 1, assuming that the stock opens @ $52.50 (this is unchanged from the previous closing price -- because the price decline is due to the stock going ex-dividend): $3.26.
     

    After the dividend is paid, anyone who was assigned an exercise notice (and therefore did not earn the 50-cent dividend) can buy the stock by paying $52.50. When that investor sells the same call option @ $3.26, he/she collects $0.76 in time premium (i.e., the net cost of stock is $49.24). This is a $26 additional profit compared with the person who was not assigned an exercise notice. Sure, that person has the $50 dividend, but you have $76 instead of the dividend  

    The key point is that It is also $26 better than the person who exercised the call and collected the $50 dividend. therefore, the person who exercised the call under these conditions has made a $26 mistake.

    When you exercise a call, you are making a trade that is equivalent to buying stock and selling the 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 the value of the dividend, collecting the dividend as the only payment for that put.

    The former call owner who exercised and now owns stock, collects the $50 dividend, and has something he/she did not have before the exercise: considerable market risk. The stock is $52.50, and is not very far above the $50 strike price -- and there are still 13 days to go before expiration arrives. The chances that the stock will slide much below $50 is not huge, but it is large enough to cause some concern. And that is the reason that the call should not have been exercised. 

    This is not something about which to complain. The people who are crying over the lost dividend never understood options well enough to consider re-establishing the position and adding to their overall profit.

    This explanation is basic to understanding options and how they work. Understand this concept, and you are on your way to being a trader.

    Person B. Some options should be exercised for the 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. For the exercise to be the mathematically correct choice, there should be zero time premium in the option and its Delta should be 100.

    Person C. There’s not much to say. He is option ignorant. The market maker (MM) would always sell the put (same strike price, same expiration as the call option) instead of exercising. Note: Selling the put is equivalent to buying stock and selling the call. So, instead of exercising and collecting the $0.50 dividend, the MM would sell the put and collect (in this example) ~$0.76. Any time the MM can get more than $50 for that put, it’s free money -- with identical risk --compared with exercising.

    Person D would have been correct, if he had stopped sooner. His first sentence is true. The second is gibberish.

    To answer your question: No, I am not always right. Nor is everyone else always wrong. You merely quoted four people who know not of which they speak/write.