Among my traders at Option Pit, one of the more popular banking stocks to trade is Goldman Sachs (NYSE: GS). It makes sense as the stock is somewhat expensive. It has a nice amount of implied volatility (IV), which when combined with price of the underlying produces a lot of time premium in the options. I was recently talking with an options trading student about a possible at-the-money calendar play in the stock when we realized that GS had a dividend during the March cycle. The student, smart but still newer to options, immediately said, “We can’t trade a calendar, I might get assigned on the call.” I explained, “Have no fear; there is NO way you get assigned on this call if we are still in this calendar.” Here is how I knew.
If I am short a GS 165 Call, what does that really represent? If the stock climbs above $165, I am obligated to sell the stock at $165, but below that level I get to keep my premium. Is there a way to recreate that position using puts and stock? There is: sell a put and sell GS stock. As Goldman crosses below $165 the stock will be ‘put’ to me, and I will be forced to buy GS for $165. However, if I sell the GS stock at the same time as the put, I make money on the stock trade as GS drops. Conversely, if GS is higher than $165 at expiration, my put will go out worthless but my stock position will lose value as the underlying rallies. This is exactly the same payout as a short call.
Like all things option, the put-call parity formula holds the relationship between the stock, the call, and the put together. It states that the call minus the put must equal the price of the underlying minus the strike price plus the cost of carry or:
C-P = S-X + (I-D)
Now let’s add some real numbers to our example above.
GS — $165.05
Strike — 165
Mar Call — $4.90
Mar Put — $5.00
Dividend — .35
Interest — .20
If we plug in the numbers do our totals add up?
4.90-5.00 = 165.05-165 + (20-.35) – .10 = -.10
Yes, our numbers add up! So, what does this have to do with exercise and assignment? Everything! If a trader decides to assign me on a call that is in the money, the trade is taking the stock, while giving up the insurance value of that call. Basically, the trader is saying that the downside insurance that the call provides is not worth the value of the dividend. In essence, the trader SOLD the value of the downside insurance for the dividend. What is another way of selling downside insurance? That is right, selling a put …
When we get assigned on a call for a dividend it is synthetically the same as buying a put for the price of a dividend. This brings us to that synthetic, so let’s fast-forward to when GS goes ex-dividend. Suppose GS looks like this:
Stock — $165.05
Strike — 165
Call — $3.90
Put — $4.10
Dividend — .35
Interest — .10
The assigner has two choices, he can:
1. Exercise a Goldman call and collect .35
2. Sell a put and collect $4.10
Pretty easy decision for the trader isn’t it.
While all of this math might seem complex, it converts into something that traders can do pretty easily — judge the price of a put. Generally speaking, if one is short a call that is going ex-dividend and the value of the put on that strike is greater than the amount of the dividend, there is almost no chance you will be assigned on that call, so rest easy.
Follow Mark Sebastian on Twitter @optionpit.
