Covered call writers know that early exercise is extremely rare. Call buyers are generally better off selling the option rather than exercising early. In this article we will evaluate why a call buyer may choose to exercise an in-the-money call option prior to expiration by evaluating the choices available to these option holders.
Value of a call option
Call value = intrinsic value + implied volatility + interest rate value – dividend value
Interest rate value factors in because of the benefit of spending less money for calls than actual shares and earning interest on the cash not spent. Dividend value factors in as a result of the dividend being received by the share holder and not the option buyer.
The key factors here are that the only potential negative impacting option value is the value of a dividend and the other three can never be less than zero. This means that if a stock does not generate a dividend, the options should never trade less than parity (intrinsic value only) and therefore should not be exercised early.
Hypothetical example
- BCI is trading at $50.00
- The $40.00 call expires in two weeks
- The stock goes ex-dividend tomorrow
- The dividend to be distributed is $1.00
- The theoretical value of the $40.00 call is $10.00 (trading at parity, all intrinsic value with no time value component)
- The call has a delta of 100 (1- same characteristics as the stock)
Available choices for the option holder
1- Hold the option
Assuming no other changes in investor demand for the security, the stock will lose $1.00 of value on the ex-date and open at $49.00. Since the option is trading at parity with a delta of 1, it’s value will be $9.00. In this instance, we are guaranteed a loss of $1.00 in this trade.
2- Exercising the option
If the holder exercises the option, shares will be purchased at $40.00 and the option holder then becomes a share owner. Because of the loss of the $10.00 option value, the shares are purchased, in reality, for $50.00 ($40.00 + $10.00 option premium). When the stock goes ex-dividend, the shares will drop in value to $49.00 but the former option holder, now share-owner, will capture that dividend. It is apparent that the exercise of the option is a better choice than holding onto the option.
3- Selling the option and buying the shares
If the option is, in fact, trading at parity ($10.00), this approach is exactly the same as early exercise because the option is replaced by the shares in both cases. However, if the option is trading above parity (has a time value component), say $10.25, this third choice would be the best. We are giving up our right to buy at $40.00, $10.00 below current market value, but receiving $10.25 in return. The loss in share price on the ex-date is compensated for by capturing the dividend.
Discussion
Early exercise of a call option is extremely rare and only makes sense when there is a dividend associated with the underlying security and the ex-dividend date comes prior to contract expiration. A trader may consider early exercise the day prior to the ex-date.
Coming soon: Put-Selling DVD Program (early bird discounted ordering in a few weeks)
Put-Selling DVD Program
Ask Alan videos…WOW
My team continues to amaze me. Wait until you see the new graphics for future Ask Alan videos.Take A Sneak Peak At The New Intro Theme.
Ten selected Ask Alan videos can be accessed from the top black bar of these web pages and the entire library of one hundred ten Ask Alan videos can be accessed for free by our Premium Members by scrolling down on the left side of our premium site.
Monday’s live seminars in Colorado:
Denver, Colorado
Monday May 18th…click for details.
7 Pm – 9 PM
I will be focusing on covered call writing but will also provide a segment on selling cash-secured puts.
Same day: Boulder, Colorado
Group- AAII Sub Group- contact
Clint Heiple
720/562-8067
Frasier Meadows Retirement Community
350 Ponca Pl, Boulder, CO 80303
(303) 499-4888
1:30 PM – 3 PM
Market tone
US markets rose to new highs on Thursday despite weak retail sales, industrial production and consumer sentiment. These stats may delay the Federal Reserve’s first rate hike.This week’s reports:
- According to the Job Openings and Labor Turnover Survey, or JOLTS, nearly 5 million jobs were open at the end of March, little changed from the 15-year high set in February.
- US employment increased by 3 million jobs in the 12 months through March, matching the annual job gains last seen in the late 1990s.
- Initial jobless claims fell slightly to 264,000. The four-week moving average now stands at 272,000, the lowest number since April, 2000
- April retail sales were unchanged from the prior month, below expectations of a 0.2% increase. Year-to-date, retail sales are up 1.9% from the same period last year
- The Producer Price Index (PPI) declined 0.4% in April, well below the expected 0.1% increase. Producer prices have declined in 5of the past 6 months and are down 1.3% from April 2014
- US industrial production was down 0.3% in April from the prior month, the fifth straight month of declines. The strong US dollar was a key factor holding back on the production of US exports
- The University of Michigan Index of Consumer Sentiment dropped 7.6% in April to 88.6 below estimates
For the week, the S&P 500 rose 0.3% for a year to date return of 3.1%.
Summary
IBD: Confirmed uptrend
GMI: 6/6- Buy signal since market close of May 11, 2015
BCI: Cautiously bullish favoring out-of-the money strikes 3-to-2. A bit more aggressive than the past few weeks.
Wishing you the best in investing,
Alan ([email protected])
Premium Members,
Premium Members,
The Weekly Report has been uploaded to the Premium Member website and is available for download. Look for the report dated 05/15/15.
Also, be sure to check out the latest BCI Training Videos and “Ask Alan” segments. You can view them at The Blue Collar YouTube Channel. For your convenience, the BCI YouTube Channel link is:
http://www.youtube.com/user/BlueCollarInvestor
Best,
Barry and The Blue Collar Investor Team
Colorado skies:
Arrived in Denver for my two seminars on Monday. Looked like I was in a Stephen King novel./ CLICK ON IMAGE TO ENLARGE & USE BACK ARROW TO RETURN TO BLOG.
Alan
Later in the day, a nice walk down the 16th Street Mall
Hi Alan,
I have completed one full year of the BCI methodology:
May 2014 – $40,000 Start
May 2015 – $57,234 End
That is a nice 40% Year over Year pop! Wish my professional guy
would get even a quarter of that!
Still made some dumb mistakes along the way and one poor month (Oct
cycle) where I gave back more than half my gains trying to make-up for
a couple of losing trades.
But nine very positive cycles that carried my through.
Thanks Alan and take care,
Jim
Jim,
You made my day!
Thanks for sharing with our BCI community.
Alan
Alan:
When you indicate we should have a diverse mix of no less than five industries represented are you using the S&P Sectors, IBD groups or something else to divide the pool of eligible stocks? I am both busy and lazy; therefore willing to be a member to have you do the hard work for me. It would be great if you listed the industry group for each screened stock under the Comments section of each report.
Larry
Larry,
Check the “running list’ mid-report. Not only do we list the industry segment name adjacent to the stock but also the ranking of that industry for both the current week (letter to the left) and the previous week if that stock was on our list last week.
One less thing to concern ourselves with.
Alan
Premium Members,
The Weekly Report has been revised and uploaded to the Premium Member web site. The stock “AMBA” had a typo in the stock screening section but was correct on the Running List.
Look for the report, “Weekly Stock Screen And Watch List 05/15/15-RevA” on the Premium Member web site.
Best,
Barry and The Blue Collar Investor Team
The weekly summary differs on this blog post from the 5/15 Weekly Stock Screen and Watch List. Which is correct?
This is the latest weekly summary:
WEEKLY SUMMARY:
For the week: The S&P 500 Index declined by 0.3%% for a year to date return of 3.1%.
IBD: Confirmed Uptrende
GMI: 6/6- Buy signal since market close of May 11, 2015
The GMI is an independent index developed by Dr. Eric Wish, Professor at the Univ. of MD. The GMI uses 6 specific market
measurements to determine the direction of the market. (http://wishingwealthblog.com/)
BCI: Cautiously bullish favoring out-of-the money strikes 3-to-2. A bit more aggressive than the past few weeks.
Alan
Premium Members,
The Weekly Report has been revised and updated. There were two changes:
[1] The Friday closing price of LAD has been corrected.
[2] The summary section did not update correctly. The Weekly Summary on the first page is now correct.
Please look for the report dated 05/15/15 RevB.
Best,
Barry and The Blue Collar Investor Team
Hi Dr. Alan:
Your writing is very easy to understand, that’s good for me & also the Selling Calls & Puts is very good income generating part of the trading. I like to read your blogs all the time. I thank you for opening up my eyes. I appreciate your help.
Yadao
Thanks for your kind and generous comments…Alan
Denver seminar:
Thanks to the AAII Denver Chapter for coming out and filling such a large room and for your warm hispitality.. CLICK ON IMAGE TO ENLARGE & USE BACK ARROW TO RETRN TO BLOG.
Alan
Dr. Ellman,
I listened several times of your covered call series 1-8 on YouTube. It is the most helpful series I find on the subject. After I listened to your lecture, I decided to do a covered call on qcom, which I have been hold for over 15 years ( so you know I am not a good investor). I sold 13 contracts at strike price $71, expiration date will be next month 19th. but when I put order in, you said choose price between bid and ask, I chose one but it actually lower than actual price, so it filled right away. Now I saw qcom price dropped quit bit, and bid/ask price also dropped. But in gain/loss column showed over $300 gain. what does this mean? You mentioned exit strategy: always buy back your option. I do want to keep the stocks. you have 20%/10% principles. do I need to buy back right away once lowered 20% or should I wait for stock price to go up? does that mean my initial option selling price drop along with stock drop?
I appreciate your help.
Respectfully,
Lina
Hi Lina,
The $300.00 gain is most likely an accounting procedure used by brokers showing us that if the option was bought back at the current price there would be a $300.00 credit based on the price you sold initially. So if you sold for $1300.00 and bought back for $1000.00, you have a credit of $300.00
Yes, buy back the option when it’s price reaches the 20%/10% guidelines as detailed in my books/DVDs. If you sold an option for $1.00 per share, buy it back for $0.20 or less in the first half of a contract. Then be prepared to re-sell another option or the stock depending on your assessment of the stock and time within the contract. As an example, we are early in the June contracts so I would be more likely to look to “hit a double” than I would to roll down unless share price was really declining rapidly.
Alan
Using the Ellman Calculator multiple tab, what stock price do you put in Column B when you keep a stock the next month. The original purchase price or the market price when you sell the next call? Thanks
Ron,
The Ellman Calculator is designed to allow us to make the best financial decision at any given point in time. If the strike is out-of-the-money, the decision is to sell the stock and use the cash in another position or to sell a call based on current market value…therefore we use current market value.
If the strike is in-the-money, our decision is to allow assignment and sell at the strike price or roll the option based on the near-month strike…therefore we use the strike price as our cost basis.
As a general guideline, we use the lower of the strike and current market value.
The calculations are different for tax purposes. For that, you can use the Schedule D located in the Elite version of the Ellman Calculator or leave it in the hands of your tax advisor). Since you are a premium member, you have access to this Elite version for free in the “resources/downloads” section of the premium site.
Alan
Alan:
If I sell a call option and the price of the stock goes beyond the strike price can the buyer of that option exercise the contract at any time prior to the expiration date or must they wait until the expiration date (prior to 4:00 pm) to purchase the underlying.
Thanks,
Mike
Mike,
Since we sell “American Style Options”, the holder of the option has the right to exercise at any time up to 4 PM ET on expiration Friday. The good news is that early assignment is rare because the holder is giving up time value if exercising early. Rare exceptions are related to dividend distributions.
Alan
VISA: Early exercise:
One of our premium members wrote me that he bought V @ $65.65 in April and sold the May $66 call which was exercised early on 5-12-15. In my books and DVDs I discuss early assignment usually related to dividends and , if it occurs, it is the day before the ex-dividend date. That was the case here as shown in the screen shot below. CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.
Alan
Hi, Alan,
Thanks for the great website, books, and videos. I’ve learned a lot and look forward to learning more.
Here’s my question: When a stock or ETF I’ve purchased falls off your buy list and watch list, should I sell ASAP even if I would incur a loss? Or should I wait a while in the hope that the stock will rebound and break even or produce a small profit before I sell?
Thanks again.
Mark
Mark,
When a stock or ETF is bumped from our watch list and it is currently in your active portfolio, it is managed precisely as described in the exit strategy chapters of our books and DVDs. At that point management is not based on its inclusion or elimination from our watch list.
If, however, a stock is sold mid-contract and we need a replacement security, it is selected from the most recent stock or ETF report.
Good question.
Alan
Premium members:
This week’s 6-page report of top-performing ETFs and analysis of ALL Select Sector Components has been uploaded to your premium site. The report also lists Top-performing ETFs with Weekly options.
***PSQ (Inverse ETF for Russell 2000) had a 1-for4 reverse stock split today. We left that security off the Inverse ETF comparison chart because the chart would be unreadable for today only. It will be back next week.
For your convenience, here is the link to login to the premium site:
https://www.thebluecollarinvestor.com/member/login.php
NOT A PREMIUM MEMBER? Check out this link:
https://www.thebluecollarinvestor.com/membership.shtml
Alan and the BCI team
On May 18th (Monday) I bought stock in and sold a covered call for SYN(SYNAPTICS INC from your running list). The call was SYNA June 26, 2015 $95 Call.
The question is that this seems to be a 6 week contract. Comment?
Just got you encyclopedia on Covered Calls. It is a very insightful book and I’m learning lots.
One very tricky area is the technical analysis of a stock utilizing trends, MCAD and stochastic’s. It would be great if you’d post examples and ask questions that we can answer and compare with your analysis a week later.
Joe
Joe,
Several of the stocks on our “running list” have weekly options as well as the traditional monthlys. SYNA (had a nice pop up today!) is one these. If you check the third column from the right, you will see a “Y” if the stock also has weeklys. You sold a weekly which expires a week after the monthly. No harm here just manage as shown in the Encyclopedia.
I have made a note of your suggestion to write more about technical analysis. In the interim, put in the term “technical analysis” into the google search tool at the top of our web pages…should keep you busy for a while!
Alan
You mean”hit a double” mean that I can buy back the option when the price reaches the 20% guidelines and sell it when the price goes up again? If it doesn’t go up, I just keep the stock? or should I wait for 2nd half the cycle and buy back at 10%? If I sold at 90 cents, now it’s only worth 50 cents, my premium doesn’t reduce 40 cents, I can still keep the 90 cents. Is that correct?
Thank you again. I really appreciate your help!
Lina
Lina,
Excellent, you’re correct on both questions. “Hitting a double” means buying back the option at 20% or less and re-selling the same option if share price rises. If it doesn’t, you can roll down to a lower strike or sell the stock if price continues to decline more than the overall market.
Yes, you keep the entire $0.90 you generated when you sold the original option even if option price declines during the contract (it usually does even if share price remains the same due to time value erosion-theta).
Keep up the good work.
Alan
Alan, what a great site and service. I have been getting you informational emails for a while now. Unfortunately circumstances pushed me out of the market place. Im kind of revving myself up to get back in the game.
I would like some information on time lines for trading or exercising call options.
Can a call be purchased and sold in the same trading session.
Also lets look at exercising a call in the same session. I could see liquidity issues on selling the option back immediately but exercising seems like it would not be an issue unless there are constraints of settlement times. So I guess the question is can you buy a call exercise it and sell the stock the same session?
Thanks
Curt B.
Curt,
Thanks for your generous comments.
Options can be bought and sold the same trading day much like stocks and ETFs. Accounting settlement may take a few days. Exercise of those options and having the shares in your account can take up to 24 hours so I can’t give a definitive answer on that question…sometimes yes and sometimes no.
However, it would be quite rare to buy an option and exercise it in the same day because you would be forfeiting the time value remaining in the option. In other words, we would make more money selling the option than exercising it and selling the shares.
Please check the calculations before executing any trades that you alluded to in your questions.
Alan