Dividends & the Early Exercise of Call Options

Published on: Jul 06 2016 by John Critchley

By:  John J. Critchley, Jr.

Senior Option Specialist / Option Principal

 

Do you own a stock that recently went Ex-Dividend and the day before the Ex date there was enormous activity in the options. An perfect example was last year when Apple’s option volume rose to more than a million contracts as activity swelled in its deep in-the-money contracts that carried large open interest.  Do you ever wonder why there is so much activity in deep in-the-money options before a large dividend in an underlying?  Here’s why:

 

 

Dividends & Early Exercise of Call Options

An option that can be exercised any time during the life of that option.  Exercising an option before expiration is called Early Exercise.

 

When a dividend is paid, only shareholders of the common stock are entitled to the payout.  There is right to the dividend for owners of call options in the underlying.

Since call options holders are not entitled to dividend payments, the day before the Ex -Dividend, the owners of call options must make an economic decision whether it is better to hold the option or exercise it into long stock.

A common strategy among professional option traders is to buy/sell large quantities of in-the-money call spreads just prior to an ex-dividend date of an underlying that has a substantial dividend.  The trader then exercises the long side of the spread and is left with an initial residual position consisting of short calls and long stock.   There are instances where non-professional option traders may not understand the benefit of exercising a call option early and may unintentionally forego the value of the dividend. The professional trader is then only ‘assigned’ on a portion of their short call position and therefore profit by receiving a dividend on the stock used to hedge the calls that are not exercised.

Let’s use a simple example that doesn’t use call spreads to simplify the concept of dividend spreads.

 

Example #1 – Basic Example – XOM @ 100    on the Thursday before July expiration

 

Dividend= $ 1   Stock Ex dividend the Friday of July expiration.

 

July 70 calls = $ 30- make the assumption that there is no open interest on this line.

 

Trader A buys 1,000 calls from Trader B @ $30 

 

Trader B buys 1,000 calls from Trader A @ $30

 

 

Trader A exercises all his calls-   Position is now long 100,000 common & short 1,000 July 70 calls

 

Trader B neglects to exercise his options- Position is now short 100,000 common & long 1,000 July 70 calls

 

Let’s see what happens on the next day when the stock opens up after going ex dividend:

 

Stock opens at $99 after adjusting for the $1 dividend.

 

Trader A collects $100,000 in dividends.  His common position is down $1, but so is his short July 70 calls.  Therefore, the Net P-n-L is + $ 100,000

 

Trader B has the unfortunate circumstance due to his negligence of having the opposite position and thus an opposite P-n-L (-$100,000).

 

It is not uncommon when there is a company with a large dividend that there is enormous activity in the deep in the money calls the day before the stock goes Ex-Div.  For this trade to be profitable there must be a large dividend plus a large open interest in the strike price.  Traders that do these trade are counting on some retail customers not exercising their deep in the money call options.  The equation that a trader must take into account when doing the trader is how many options do they think might not be exercised. Remember, the trader must pay commissions and exchange fees when doing the trade, so if all the short calls get assigned to the trader they are out the commissions.  This can be very expensive. 

 

Example #2- Key Point-There is a residual position after this trade-

 

 Same Basic Example but a week before expiration, – XOM @ 100

 

Dividend= $ 1   Stock Ex dividend.

 

July 70 calls = $ 30- make the assumption that there is no open interest on this line.

 

Trader A buys 1,000 calls from Trader B @ $30

 

Trader B buys 1,000 calls from Trader A @ $30

 

Trader A exercises all his calls-   Position is now long 100,000 common & short 1,000 July 70 calls

 

Trader B neglects to exercise his options- Position is now short 100,000 common & long 1,000 July 70 calls

 

Let’s see what happens on the next day when the stock opens up after going ex dividend:

 

Stock opens at $99 after adjusting for the $1 dividend.

 

Trader A collects $100,000 in dividends.  His common position is down $1, but so is his short July 70 calls.  Net P-n-L + $ 100,000

 

Trader B has the unfortunate circumstance due to his negligence of having the opposite position and thus an opposite P-n-L (-$100,000). 

 

Trader A – Position is now long 100,000 common & short 1,000 March 70 calls- Synthetic Short 1,000 July 70 Puts

 

Trader B – Position is now short 100,000 common & long 1,000 March 70 calls-

Synthetic Long 1,000 July 70 Puts

 

 

The following week XOM goes to $50.  What is the consequence of this fall?

 

Trader A-   Synthetic Short 1,000 Mar 70 puts

 P-n-L    -$2,000,000(on underlying movement) +$100,000(on dividend play) = Net P-n-L of -$1,900,000

The position breaks even until the underlying breaks through 70, where the trader is now naked long 100,000 common.

 

Trader B- Synthetic Long Puts-

Net P-n-L (+ $1,900,000)

The position breaks even until the underlying breaks through 70, where the trader is now naked short 100,000 common.

 

 The relevance of this example is to show that the trader must be aware of possible unintended consequences of this seemingly risk free trade. In order for a trader to consider doing this trade with the deep in the money calls, one must first see where the price that the puts on that strike price are trading.  If the dividend is greater then the price of the puts, then the trade may be worth doing. 

 

Example #3  - Traders can buy puts to hedge the downside risk.

 

 In order to avoid what happened in Example 2 to Trader A.

 Trader A is long 100,000 common & short 1,000 July 70 calls- Synthetic Short 1,000 July 70 Puts.  As soon as the underlying opens the next day he could go into the open market and buy 1,000 July 70 puts at, for example .20 cents.  He then is fully hedged and has locked in .80 cents on the overall trade.

 

 

Conclusion-

 

These ‘dividend plays’ are executed by traders in order to try to capture the dividend when the other owners of deep in-the-money call options do not exercise their call positions.  If the dividend is greater than the price of the puts, then exercising the calls may be worth doing if the trader understands the downside risk of the residual position. Also, be aware that a spike in option volume is not always an indication of directional interest, but rather just might be traders executing a dividend play.  Being an informed investor is the key to success. Stay informed, be profitable.

 

 

 

Embrace Options, do not fear them.

 

 

 

Stay tuned………

 

 

Disclaimer


We are not liable for any trading decisions made by any reader. NO advice is given or implied. The information offered in  this article is for demonstration purposes ONLY and should not to be either construed as an offer or considered to be a recommendation to buy or sell any options .

Your use of this information is entirely at your own risk. It is your sole responsibility to evaluate the accuracy, completeness and usefulness of the information. You must assess the risk of any trade with a professional broker, or financial planner, and make your own independent decisions regarding any trades mentioned herein. This is not a solicitation to buy or sell any options, or to purchase or sell any credit spreads. Trading options only carries a high degree of risk, is not suitable for all traders/investors, and you may lose all of your premium money invested in the options. If you have never traded options before, we strongly recommend that you read a little background information made available by the government. Only you can determine what level of risk is appropriate for you. Also, prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options.

Past performances DO NOT guarantee future results. Please consult with your own independent tax, business and financial advisors with respect to any trade. We will NOT be responsible for the consequences of anyone acting on this purely demonstration material.

 

 

 

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