May 30, 2017
9 minutes read
Holding shares in a company gives the shareholder the following rights:*The right to transfer ownership,
*The right to dividends,
*Voting rights, and
*The right to residual income and assets.
What this means is that shareholders are free to sell their shares, take dividends when they are paid, vote at shareholder meetings and receive any residual funds upon liquidation of the company. The great majority of investors exercise only the first two rights, i.e. the right to transfer ownership and the right to dividends, while the last two rights are exercised only occasionally. Holders of call option contracts have the right to buy shares under the terms and conditions of the contract. But they do not yet hold the shares, so they cannot benefit from the rights of shareholders as long as the call option contract has not been exercised.
When the company pays dividends
As a result, when the company underlying the contract pays a dividend, the call option holder will not receive it. The only way that the holder of a call option will be able to receive the dividend is to exercise the contract before the dividend is paid. The holder of the option then becomes a shareholder in the company and automatically receives the right to the dividend*. When you buy call options, it is important to know if any dividends will be paid before the end of the contract.
Prerequisites to early exercise
Certain conditions must be met in order to benefit from exercising a contract before it expires** Naturally, a dividend needs to be paid, plus the call option needs to be in the money and its time value needs to be less than the value of the dividend. Why would you exercise an out-of-the-money call option and pay an above-market price for the shares to obtain a dividend? If you absolutely want the dividend, you would be better off buying the shares on the market than exercising your call options.
When the company does not pay dividends
Setting aside certain exceptional cases**, it is ill-advised to exercise a call option early on the stock of a company that does not pay dividends, for the following reasons. First, imagine that the holder of a call option set to expire in a month, eventually wants to have the stock in their portfolio, and that the call option is deep in the money. The holder might be tempted to exercise the contract before it expires, but this would mean paying the value of the strike one month before the contract expires, so any interest that could be earned during this period would be lost.
Second, holding the call option gives the investor some protection against the price of the shares falling to below the strike price during the life of the option. If the share price falls below the strike price, exercising the call option early will result in a loss that could otherwise have been avoided. So, regardless the probability of a drop in the price of the stock, it is preferable to hold on to the call options until they expire, to guard against this possibility. Lastly, if the price of the underlying shares increases, the holder of a call option might be tempted to exercise it and then sell the shares at a profit. In such a case, it would still be preferable not to sell the call options, in order to collect whatever time value may be left on the option.
What about put options
In the case of American-style put options, in contrast to call options, it may be worthwhile to exercise them before they expire, even if the stock does not pay dividends. A put option that is sufficiently in the money may be exercised before it expires in order to collect the strike price and invest the funds at the current interest rate. Since the put option also serves as insurance, in this case against an increase in the stock price to above the strike price, the odds of the stock price rising above the strike price must be practically nil to consider exercising it early.
Suitable conditions for the early exercise of a put option
Suitable conditions for the early exercise of a put option are a combination of the following: a put option that is deep in the money, a high enough interest rate, and sufficiently low volatility. If a put option is deep in the money and the underlying stock has low volatility, the odds that the security’s price will rise above the strike price will then also be very low. In addition, if interest rates are high, it will be worthwhile to consider exercising the put option before it expires, in order to collect some interest income on the value of the strike price.
Early exercise of a put option on a stock that pays dividends
Lastly, when the holder of a put option wants to exercise the contract before it expires because the above conditions have been met, this should only be done once the dividend has been paid. Imagine that an investor holds shares that pay dividends and has bought put options to protect the position. Clearly it would be preferable to exercise the put options the day after the dividend is paid, in order to collect the dividend, rather than exercise it the day before and miss out.
In conclusion, before you decide to exercise an options contract early – whether a call or a put – you first need to determine whether it is advantageous. Except as noted**, it is never beneficial to exercise a call option before the expiry date if the underlying stock does not pay dividends. The only advantage to exercising a call option early is to collect dividends. So, no dividend means no early exercise! The situation is different for put options, since early exercise allows the holder to be compensated in the form of interest income on the funds that are freed up when the shares are sold. The only remaining issue is whether this interest income is sufficient to offset the risk that the stock price could rise above the strike price of your option. But as the saying is in finance, nothing ventured, nothing gained!
* Remember that only American-style options, like the great majority of stock options, can be exercised early (meaning before their expiration), while European-style options may only be exercised on the expiration date. Furthermore, it has been shown academically that early exercise is only optimal for the last dividend to be paid during the life of the option contract.
**Certain exceptional cases, such as a takeover bid or a corporate reorganization, could justify exercising options early.
Good luck with your trading, and have a good week!
The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.