Exercising Call Options
Exercise Options
A common option strategy is buying options as an investment. By paying far less than the price of 100 shares, the call buyer gets to control those same 100 shares and possibly earn a substantial profit when the stock rallies. Similarly, the put buyer controls the right to sell 100 shares and can profit when the stock price declines.
When the underlying stock pays a dividend, the option owner does not collect that dividend. Indeed, most of the time the dividend is unimportant to the call owner. However, there are situations in which the call owner must pay careful attention to the dividend and especially to the date that the stock trades ex-dividend (without the dividend). Simply stated, if an investor does not already own the shares when the stock opens for trading on that ex-dividend date, the investor is not entitled to collect the dividend.
If you own a call option, and if that option is in-the-money (ITM), you may want to exercise your right to buy 100 shares at the strike price, take ownership of the shares and collect the dividend. However, the decision is not always obvious, and this article is meant to help reach the best decision.
Risk and Reward
100 Dollars Flying
1 — When you exercise an option, you must pay cash to buy the shares. That sacrifices any interest that the cash may have been earning. This is referred to as the ‘cost to carry’ or own the shares from exercise date through the time that the option would have expired. Often this cost is too high to justify exercising the option, and the call owner is best served by ignoring the dividend. Put simply – is the cost to carry less than the dividend you will earn by owning the shares? If so, consider exercising your call option.
2 — Exercising increases risk. The call owner can only lose the value of the option. In other words, if the stock declines in value, the call may become worthless — but that’s it. The call owner cannot lose any more money. The exerciser now owns 100 shares of stock, keeps the dividend, but has picked up something else that he/she did not previously own. That is risk, and its negative — downside risk. If the stock declines in value, losses are no longer limited.
Thus, when converting a call option into stock for the purpose of collecting the dividend, the call owner essentially trades limited risk for that dividend. Sometimes that’s a good trade, and at other times it’s a bad trade. How can the investor know what to do?
Check Your Math
Arrow Dollar
3 — Exercising a call option is equivalent to selling a put option at the same strike price, and with the same expiration, as the call. That may sound confusing but look at it this way: Long call (previous position) is equivalent to long stock + long put. When you exercise a call option, or convert the call to stock, you don’t receive the corresponding put. It has essentially been sold for zero.
For that reason, it does not pay to exercise the call for the dividend, unless you believe that the put is worthless. So how do you know when that is the case?
Time is Money
Bag of Money
4 — The best guideline for determining whether it’s a good idea to exercise the option is to be certain: On the date that you plan to exercise the option (the day prior to ex-dividend day):
- The call option is trading with zero time premium. That means you cannot sell the option and collect a price above parity (the intrinsic value of the option)
- The option delta is 100
- The cost to carry is less than the dividend
5 — If the option has any time premium, it’s better to sell the option (collecting the time premium) and buy the shares (thereby being eligible to collect the dividend). There is a widespread, but mistaken, belief that if the option time premium is less than the dividend that it is right to exercise. Do not believe that. It is a huge mistake to exercise such an option.
Most option owners can safely ignore the dividend. However, if you want to consider exercising, please be certain to obey the few rules listed above before doing so.
Follow Mark Wolfinger on Twitter @MarkWolfinger.
