Our covered call writing and put-selling options can be exercised at any time from the moment we sell these options until 4 PM ET on expiration Friday. This is the definition of American Style Options, the type associated with our stocks and exchange-traded funds. Early exercise (prior to contract expiration) is rare because option holders have control of the contract obligations up to contract expiration. The cash required to purchase shares can be left in interest-bearing accounts and capital-risk can be minimized by waiting until the last minutes of the contract. There are times, however, when options are exercised early and this article will highlight the 3 main reasons for early exercise from the perspective of option holders:

  • Basic Call (Discount) Arbitrage
  • Dividend arbitrage
  • Investor miscalculation

 

What is arbitrage?

This is the simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by capitalizing from price differences of identical or similar financial instruments, in different markets or forms.

early exercise of stocks options

How Arbitrage Works

 

Basic Call (Discount) Arbitrage

The arbitrageur can buy a call option at a discount (below parity) and simultaneously sell the underlying stock:

  • Stock XYZ: $50.00
  • $40.00 call trades at $9.75 (below parity)
  • Risk-free profit = $0.25 (stock is purchased at $40.00 and sold at $50.00, less the cost of the option)

 

Dividend arbitrage

Buying in-the-money put options and buying equivalent amount of underlying stock before the ex-dividend date and then exercising the put after earning the dividend. The time value of the put must be less than the dividend distribution:

  • Stock XYZ: $50.00
  • $60.00 put trades at $10.10 (time value = $0.10)
  • Dividend = $0.50
  • Risk-free profit = $0.40 (stock is purchased at $50.00 and sold at $60.00 + the dividend is captured, less the cost of the put)

 

Investor miscalculation

Retail investors may exercise a call option with time value remaining prior to the ex-date to capture a dividend without realizing that a better approach would be to sell the option, buy the stock prior to the ex-date and capture the dividend. The criteria used is that early exercise makes sense if the time value of the premium is less than the impending dividend distribution. However, there is a better way: 

  • Stock XYZ: $50.00
  • $40.00 call trades at $10.25 (time value = $0.25)
  • Dividend = $0.50

 

Early Exercise = $10.00 (intrinsic value…buy at $40.00 as shares are currently worth $50.00) + $0.50 (dividend) = credit of $10.50 as shares are currently valued at $50.00-per-share.

Sell option, buy stock, collect dividend = ($10.25 + $0.50) = credit of $10.75 as shares are currently valued at $50.00-per-share.

 

Discussion

Early exercise is rare and generally does not benefit option holders. Arbitrage opportunities are uncommon exceptions. However, early exercise may occur due to investor error and we must be aware that ex-dividend dates (the day prior to the ex-date is the most common day for early exercise) are times when early exercise may take place even if the option buyers have better alternatives. This may be particularly important to those of us who prefer to retain our shares, perhaps to avoid negative tax issues.

 

My recent interview with NASDAQ reporter Jill Malandrino in New York City

Click here to view the interview

 

Upcoming events

The Association for Technical Analysis (AFTA): Dallas Texas

“How to Generate Monthly Cash Flow and Buy a Stock at a Discount Using Two Low-Risk Options Strategies”

Tuesday April 17, 2018 6:30 PM – 9 PM 

Crowne Plaza 14315 Midway Rd Addison, TX 75001-3505   

Click here for club website

 

Market tone

This week’s economic news of importance:

  • Case-Shiller home price index Jan 6.2% (6.3% last)
  • Consumer confidence index March 127.7 (131.0 expected)
  • GDP revision Q4 2.9% (2.8% expected)
  • Pending home sales Feb 3.1% (-5.0% last)
  • Weekly jobless claims 3/24 215,000 (230,000 expected)
  • Consumer spending Feb 0.2% (expected)
  • Consumer sentiment index March 101.4 (102.0 expected)

THE WEEK AHEAD

Mon April 2nd

  • Markit manufacturing PMI March
  • ISM Manufacturing March

Tue April 3rd

  • Varies motor vehicle sales March

Wed April 4th

  • ADP employment March
  • Markit services PMI March
  • ISM non-manufacturing index March
  • Factory orders Feb

Thu April 5th

  • Weekly jobless claims through 3/31
  • Trade deficit Feb

Fri April 6th

  • Non-farm payrolls March
  • Unemployment rate March
  • Consumer credit Feb

For the week, the S&P 500 rose by 2.03% for a year-to-date return of (-) 1.22%%

Summary

IBD: Market in correction

GMI: 1/6- Sell signal since market close of March 23, 2018

BCI: Selling all in-the-money strikes for all new positions. Currently fully invested and rolling down to out-of-the-money strikes (as they relate to current market value) when opportunities arise. Will re-adjust when the market settles.

WHAT THE BROAD MARKET INDICATORS (S&P 500 AND VIX) ARE TELLING US

The 6-month charts point to a bearish sentiment. In the past six months, the S&P 500 was up 4% while the VIX (19.97) moved up by 110%. Historically, the VIX and S&P 500 are inversely related.

Wishing you much success,

Alan and the BCI team





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