Early Exercise Due to Dividend Capture: Theoretical and Practical Applications

When we write a covered call option we are obligated to sell our shares at any time from the option sale to contract expiration if the option buyer decides to take possession of our shares. This is because we are dealing with American Style options. European Style options (apply mainly to indexes, not stocks) can only be exercised on the expiration date. Early exercise of American Style call options is rare for two main reasons:

• Most call buyers have no intention of taking possession of the underlying shares but rather want to benefit from movement of the underlying to increase the value of the purchased option
• Exercise results in capture of the intrinsic value component (if any) of the option but loss of time value (if any) resulting in sale of the option being a more lucrative choice

Ex-dividend dates

When an option is exercised early (prior to contract expiration), it is usually associated with a dividend distribution and more specifically, an ex-dividend date. In order to capture a dividend, shares must be purchased the day prior to the ex-date or earlier. If early exercise does occur due to a dividend capture scenario, it will normally take place the day prior to the ex-date. Other factors that increase the chance of early exercise due to dividend capture:

Call holders are aware the premiums will decline on the ex-date (all other factors remaining the same) because share value will drop by the dividend amount but is early exercise the best path for buyers to take?

Real-Life Example: Old Dominion Freight Line Inc. (NASDAQ: ODFL)

ODFL_ Ex-Date

On 12/4/2017, the report shows an ex-date of 12/5/2017. 12/4/2017 represents the most likely date for early exercise related to the impending dividend distribution. Let’s first do the math to see if early exercise makes sense.

What will be the dividend distribution?: www.dividendinvestor.com

ODFL: Dividend Distribution

The free website, www.dividendinvestor.com, shows a quarterly dividend of \$0.40.

ODFL Option Chain on 12/4/2017

With ODFL trading at \$127.41, the in-the-money \$125.00 call generated a bid price of \$3.30. Since the strike is in-the-money by \$2.71, the premium breaks down as follows:

\$3.30 = \$2.71 (intrinsic value) + \$0.59 (time value)

Practical application

Exercise will result in a loss of time value of \$59.00 per-contract to capture a dividend of \$40.00 per contract. This makes early exercise extremely unlikely. Had the dividend been \$1.00, let’s say, exercise would have been more likely from a practical standpoint. If early exercise does occur, it will usually take place the day prior to the ex-date and when the time value of the premium is less than the impending dividend distribution. If we want to retain our shares, circumventing ex-dates under these conditions should be part of our strategy plan.

Theoretical application

Early exercise to capture a dividend is never in the best interest of the call holder but most retail investors are not aware of this. Let’s say the dividend was \$1.00, greater than the time value component of the premium (\$0.59)

Early exercise scenario

Shares are purchased for \$125.00, \$2.71 below market value (+\$2.71)

On ex-date, option value will decline by about \$1.00 (\$1.00 not lost because option was used to buy the shares) due to share value decline by the dividend amount

Share value will decline by \$1.00 which is compensated for when the dividend is paid

Total benefit = \$2.71 (the original intrinsic value component of the premium)

Sell the option and buy the stock scenario

Instead of early exercise, the holder sells the option for \$3.30

Shares are purchased for \$127.41

On the ex-date, share value declines by \$1.00 which is compensated for when the dividend is paid

Total benefit = \$3.30 (intrinsic value + time value

Discussion

In the practical world of investing, we must factor in ex-dividend dates into our investment arsenal if early exercise is something we want to avoid. This is because many retail investors are not aware of the fact that a better path would include selling the option before buying the stock, thereby capturing the time value component of the option premium.

Upcoming event

AAII National Investor Conference: Las Vegas Nevada

October 26 @ 8:00 am – October 28 @ 1:00 pm

October 26th – 28th, 2018 (Friday through Sunday)

Market tone

This week’s economic news of importance:

• Existing home sales July 5.34 million (5.40 million expected)
• Weekly jobless claims 8/18 210,000 (215,000 expected)
• Markit manufacturing PMI August 54.5 (55.3 last)
• Markit services PMI August 55.2 (56.0 last)
• New home sales July 627,000 (640,000 expected)
• Durable goods orders July -1.7% (-1.2% expected)
• Core capital goods orders July 1.4% (0.6% last)

Mon August 27th

• Chicago national activity index July

Tue August 28th

• Case-Shiller home price index June
• Consumer confidence index August

Wed August 29th

• GDP revision Q2
• Pending home sales July

Thu August 30th

• Weekly jobless claims 8/25
• Personal income July
• Consumer spending July
• Core inflation July

Fri August 31st

• Chicago PMI August
• Consumer sentiment index August

For the week, the S&P 500 moved up by 0.86% for a year-to-date return of 7.52%

Summary

IBD: Market in confirmed uptrend

GMI: 6/6- Bullish signal since market close of July 9, 2018

BCI: Selling 3 out-of-the-money calls for every 2 in-the-money for new positions.

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

The 6-month charts point to a bullish tone. In the past six months, the S&P 500 was up 4% while the VIX (11.99) down by 22%.

Wishing you much success,

Alan and the BCI team

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies.

20 Responses to “Early Exercise Due to Dividend Capture: Theoretical and Practical Applications”

1. Joanna August 26, 2018 10:14 am #

Early assignment seems always to my benefit since I make sure that whether or not it gets assigned, I’m going to be profitable…. so getting exercised early results in both making money and a freeing up of capital that I can use to write more call options. Win win!

• Alan Ellman August 26, 2018 1:26 pm #

Joanna,

BINGO!!! Great observation. An exception, however, can be if trading low-cost basis stocks in non-sheltered accounts that may result in unwanted tax consequences.

Alan

2. Adrian August 26, 2018 12:23 pm #

There have been times where during my papertrading I would like a few more stocks to scan through. I have become quite strict on the stock-technicals and liquidity, that sometimes I can be left with hardly any stocks within my preferred price range.

I remember you had said we could use the ‘finviz.com’ screener, but if I were to use this then what are the things I should screen for, as there are so many signals both fundamental and technical?

Thank you,

• Alan Ellman August 26, 2018 1:29 pm #

The screenshot below shows the FINVIZ screener as set up in my book, “Stock Investing for Students” These parameters can be tweaked based on your personal risk-tolerance and preferences.

CLICK ON IMAGE TO ENLARGE & USE THE BACK ARROW TO RETURN TO BLOG.

Alan

3. Barry B August 26, 2018 7:22 pm #

This week’s Weekly Stock Screen And Watch List has been uploaded to The Blue Collar Investor Premium Member site and is available for download in the “Reports” section. Look for the report dated 08/24/18.

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 link to the BCI YouTube Channel is:

Since we are still in Earnings Season, be sure to read Alan’s article,”Constructing Your Covered Call Portfolio During Earnings Season”. You can access it at:

https://www.thebluecollarinvestor.com/constructing-your-covered-call-portfolio-during-earnings-season

Best,

Barry and The BCI Team

barry@thebluecollarinvestor.com

4. Karl August 27, 2018 11:01 am #

Morning Alan,

Loving your report – I just have 2 questions on it :-
1: BCI: Selling 3 out-of-the-money calls for every 2 in-the-money for new positions.
When you say this do you mean on a single stock – so in this case I would need to purchase shares in lots of 500?
Or is this over all CC you are writing?
2: For more expensive stocks, typically those above \$85 do you still write CC or do other options e.g. diagonals or PMCC?

Appreciate the help, sorry I missed you up in SF last week – was away on vacation.

Karl

• Alan Ellman August 27, 2018 4:10 pm #

Karl,

The ratio I give weekly represents an overall portfolio breakdown. A typical month for my option-selling portfolio consists of 15 – 25 positions and 50 – 100 contracts. If I sell 100 contracts, 60 would be out-of-the-money calls and 40 in-the-money calls when I give a 3-to-2 ratio.

My personal go-to strategy is covered call writing and use out-of-the-money cash-secured puts in bear or volatile markets before entering a covered call trade. We should favor stocks that are appropriate for our portfolio cash value. This will differ from investor-to-investor. Let’s say we have a portfolio with \$100k in cash and decide to diversify into 8 positions. We dedicate \$12,500.00 per position. Then we divide the price-per-share into \$12,500.00 and round to the nearest 100. That dictates how many shares to buy and how many contracts to sell. Stocks that cannot meet this framework are not considered rather than fit the stock into a different strategy.

I got a chance to meet so many BCI members in San Francisco…a real treat for me. Hopefully, we will meet at a future date.

Alan

5. Pete August 27, 2018 2:07 pm #

Trying to understand the mathematical concept of when to roll up when a stock takes off. Ex sold VEEV9/21 90c for \$3.43 on 8/22. Purchase price \$88.9, current price \$101.54. When is a good time to buy back the stock & why? Is there a formula or guideline for making the buyback determination?

Thanks Pete

• Jay August 27, 2018 6:55 pm #

Hey Pete,

Others may see it differently but this one is just going to leave you at the bus stop. It happens all the time. You will keep your 3.43 plus .1 on appreciation and 3.53 into an 88.9 purchase gives you a 4% one month return so well done!

Sure, had you never written the call you would be up 15% unrealized gain at the moment. But who knows by expiry? That’s why I try to buy at least 200 shares of any growth stock and over write only half as loss protection. – Jay

• MarioG August 28, 2018 2:26 am #

Pete,

If a stock gaps up after buying a CC, here are some general suggestions on what to do:

* See the Complete Encyclopedia, Vol1 Page 135 “Unwind Now Tab”, Pages 264-271 “Mid Contract Unwind” Strategy

* Search Blog for “Unwind Now”, “MCU”, “Mid Contract Unwind”. You will find several answers.

The above will show you the cost to close the position using the Unwind tab of the Elite Calculator or you can use my comments below for calculations as well.

*****
When a stock gaps up, the Time value of the call approaches zero.

Choices:
* Unwind the complete position and find another investment for additional profit. The guideline is to close out the position if you can find another investment that yields 1% more than the loss you received in closing out. Example: Cost to close .3%, new position should have an ROO 1.3%

* If you really feel the Underlying will still continue to rise, you could just close the option and sell another option that meets the new 1% ROO goal. But generally I look for another investment if I can exit at a low loss.

* A quick way I find my cost to close without the calculator is to look at the time value of the of your option.

** I usually use a 0.1% or 0.2% threshold when doing a MCU exit strategy.

** Say you have 200 Shares Strike 50 ITM CC. Your Return cost basis (I call this my RCB) is \$50 for ROO Calculations. If your original Sell to Open transaction gave you a 3% (goal is about 2-4 with Alan) gain, that meant your original Time value was 1.50 (.03 x 50) when you entered the trade. (Check ROO = 1.5 / 50 = 3%). For 200 shares your profit is \$300 (200 x 1.50)

** Now for the closing, using the 0.1% loss I want to have that means the closing time value must be 0.05 or less (0.1% of 50) when I exit. (I am ignoring commission costs for now.). If you include commission and your cost for a combination order (See Covered Call or unwind exit) is \$6.00 or 0.03 / share (\$6 / 200), your cost to close is not .08 per share or 0.16% (.08/50). If you only had 100 share originally, then the commission cost is .06 / share and your cost to close jumps to 0.11 / share or .22% (.11 /50)

** How can guarantee the Time value of .05 (0.1% loss) with a Credit Limit Combinations order for gap up In The Money case? The Credit Limit is the Current Price of the stock less the Premium of the option for the BTC.

** I have shown elsewhere in this blog that the Credit Limit is also equal to the Strike – Time Value for an ITM CC only (This DOES NOT apply for OTM Combination orders).

** So for your Strike 50 CC, for a time value of .05, you must fill an order with a credit limit of 49.95 (50-.05). That will guarantee you a 0.1% loss. It’s amazing how that works out when you document your trade and see your cash account results.

** I usually place a Sell CC combination order to unwind a CC at 0.1 to 0.2% early in a cycle. You never know when a Stock Price gaps up for a short time while you are away and you miss an opportunity (has happened to me several times) to unwind. I usually cancel the order by the Wed of the 3rd week of a 4 week cycle., or when I think there would be no opportunities for a new investment.

Mario

• Alan Ellman August 29, 2018 6:46 am #

Pete,

The current price for VEEV as of market close Tuesday is \$102.72 and the last trade on the \$90 call was \$12.95. This means that the time value cost-to-close is \$0.23 or 2 tenths of 1% of the real current value (\$90.00, the strike price). You have maximized your potential return and can close the entire position and use the cash to generate a second income stream in the same contract month with the same cash using a different stock. This is the mid-contract unwind exit strategy at its best.

Alan

• Alan Ellman August 29, 2018 6:51 am #

Pete,

As of market close Tuesday, VEEV was trading at \$102.72 and the \$90.00 call at \$12.95. The time value cost-to-close is \$0.23 or 2 tenths of 1%. By closing the entire position and using the freed-up cash to enter a new position with a new underlying, we can realize a second income stream in the same contract month with the same cash…the classic mid-contract unwind exit strategy. The key to initiating this strategy is that it occurs in the first half of a contract and the time-value cost-to-close is approaching zero and a new position can generate more than 1% of that time value cost-to-close.
Congratulations on a very successful trade.

Alan

6. Joe August 27, 2018 9:04 pm #

Alan, do you have a formula to calculate the breakeven price if one is doing the stock repair strategy that i can use in a spreadsheet, thank you.

Joe

• Alan Ellman August 28, 2018 6:44 am #

Joe,

BE = (Stock price when trade executed) – (Total option premium generated)

If we bought a stock at \$48.00 and sold a call for \$2.00, our BE = \$46.00.

If we implement exit strategies:

BE = (Stock Price) – (Net option credit or debit)

Same trade but then BTC the short call for \$0.40 and then STO at \$1.00:

BE = (\$48.00) – (\$2.00 – \$0.40 + \$1.00) = \$45.40

Alan

7. MarioG August 29, 2018 2:24 am #

8/28/18
Observations, Comments on Cash / Margin Accounts in Individual and IRA Accounts:

I have Individual and IRA accounts at Fidelity and Etrade. I also have a Joint Trust Account at Fidelity. The accounts were Cash accounts with approvals for Covered Calls and Cash Secured Puts (Fidelity Level B, E*trade Level 2).

After working 24 months with Alan’s methodology. I decided to request to convert my accounts to margin accounts (where possible) initially for the following main reason: ability to perform credit and debit spreads.

I was not interested in using the margin to increase my trading buying power or leverage, just ability to trade spreads in the future..

What I found from the conversion to margin and 5 months later were unexpected benefits and discovery of some brokerage policy differences and limitations.

I summarize what I found below for each account.

*****
Fidelity Individual Account: For spreads, submitted submitted request for Investment Objective: Most Aggressive, Trading Strategy Level C. Filled online form to request a margin account.

* All cash moved to Type: Margin When I place a Covered Call or any trade the Combination order form defaults to Cash type: Margin. Does not mean I am borrowing margin for my trade. As long as use my available cash there are no charges.

* To avoid any borrowing from margin as I place my covered calls by monitoring the balance “Available to trade without Margin impact”

* Found a benefit from the margin account was that I could not be subject to a “Good Faith Violation”. With a cash account I was subject to the violation (Buy, then Sell, then buy with unsettled funds, then trying to sell before paying for the purchase with settled funds.) Settlement period is 2 days. I found this out as a result of long trades with in my IRA account. See below.

*****
Fidelity IRA Account: For spreads, submitted a special Spreads agreement for an IRA (had to be mailed).

* When trading with a low amount of cash some long position, I found out I could possibly have a “Good Faith Violation” if I sold a position before funds settled (Was over 90% invested). Found I would have to wait 1 or 2 days before selling a position I had purchased. I did not have this problem with my margin account for similar trades.

* After talking to several Fidelity Representatives, I was informed I could enable a Fidelity IRA feature called “Limited Margin” (online request) which would completely eliminate the “Good Faith Violation” as long as I had enough cash in unsettled funds to place the trade. You are not borrowing funds on margin, since that is illegal in an IRA.account. I understand Schwab (and maybe others) have a similar “Limited Margin” feature.

* With Limited Margin enabled, I found I needed to monitor a balance called “Limited Margin – Overnight Buying Power” to determine my actual cash available for new trades.

****
Fidelity Joint Revocable Living Trust Agreement Account: This account has Joint funds I have with my wife and I am using with the goal of only trading ETFs. I submitted a joint request to upgrade the account to Level B to cover Cash Secured Puts. Spreads are not allowed in a Trust Account.

*****
*****
E*trade Individual account: For spreads, submitted an online request for Level 3. Filled online form to request a margin account.

* To avoid any borrowing from margin as I placed my covered calls I monitored a balance “Net Cash / Margin Balance”. If this balance is negative, you are borrowing on Margin.

* This account is not subject to a “Good Faith Violation”, just like the Fidelity Individual margin account.

*****
account.

* The E*Trade IRA account is subject to a “Good Faith Violation”. E*Trade does not have a feature similar to the “Limited Margin” the Fidelity IRA has. If I buy a long position with unsettled funds, I must wait the 2 days needed for the previous trade to settle before I sell the new position.

* To avoid any borrowing from margin as I place my covered calls I monitor a balance “Net Cash Balance”.

*****

Mario

8. Mike August 29, 2018 5:18 am #

Hi Alan,

I really appreciate your work and website as my wife recently signed up and we have been focusing on covered calls.

Having been involved in security trading for the last 25 years while doing commercial real estate brokerage full time for 45 years, I have mastered some interesting techniques in stocks, options and ETFs.

One strategy of late is fascinating to me for which I’d love your opinion:

To begin, long equal dollar amounts of TNA and TZA.
As you know, these are 3X bulls and bears clocking the same index on a percentage basis.

The equal dollar amount keeps the principal at parity.
Obviously need to long at least 100 shares of the more expensive one.

Then, short as many weekly calls as possible for each one.

In my recent experience, Friday TNA calls yield the most whereas the most I’ve seen on TZA happens on Tuesday and Wednesday.
On Fridays roll the TNA ITM call, and if the TZA is in ITM (sometimes both could be), then long it back for next Tuesday’s short.

I can see losing money if the market makes a large move and the ITM call costs more to buy back than all premiums collected, so that’s the only downside, but it is a risk.

It seems the premiums for this play are particularly fat on NUGT and DUST as they are also 3X bulls and bears, but the volatility might inflict more losses than wins, or at least cause ulcers.

Thank you,
Mike

• Alan Ellman August 29, 2018 7:37 am #

Mike,

To give a meaningful evaluation of a specific strategy approach, paper-trading over several months would be a requirement. So let’s leave that open. That said, I’ve made it clear over the years that I, personally, avoid leveraged ETFs. They simply do not align with my personal risk-tolerance. For others, they may be appropriate.

Covered call writing is a conservative strategy generally geared to retail investors who focus in on small but consistent income generation with capital preservation a key requirement. Using leveraged ETFs increases the risk component of the strategy even when using securities with opposite daily goals. A potential 50% annualized return is the enticing component.

Here are the questions I would focus in on:

1. You’ve astutely identified the cost-to-close when strikes move deep-in-the-money for these volatile securities.

2. If small caps have a good week, half the positions have had a bad week and vice-versa.

3. Amount of cash needed “on the sidelines” to close deep-in-the-money calls near expiration…leveraged ETFs can move deeper ITM faster than traditional ETFs.

4. Will Weeklys allow adequate time for exit strategy implementation?

5. Weeklys will result in 4 – 5 times the number and amount of trading commissions. What impact will that have on bottom line? Should Monthlys be used instead?

Any new strategy approach must be tested before implemented and risking our hard-earned money. If you do so, I would greatly appreciate it if you shared your findings with the BCI community.

Alan

9. Alan Ellman August 29, 2018 5:29 pm #

NEW ETF REPORT & NEW ETF:

This week’s 8-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 as well as the implied volatility of all eligible candidates.

We have added the new SelectSector SPDR ETF, XLC (Communication Services) to our weekly analysis. Although it is not currently a top-3 performer, it does have adequate option liquidity and will be part of our analysis moving forward.

New members check out the video user guide located above the recent reports.

https://www.thebluecollarinvestor.com/membership.shtml

Alan and the BCI team

10. MarioG August 30, 2018 7:22 pm #

Alan,

In the discussion of Call Holders exercising a call to qualify to receive a dividend, a disadvantage of exercising also is the fact that one then owns the stock and now the risk that comes with the ownership. The stock price can decline before selling the stock on the Ex-Dividend date or later, negating some or all the dividend you will receive.

If the dividend is only slightly larger than the time value, selling call is probably still the better choice.

I have experienced my covered calls being assigned. Sometimes I never know it was assigned till the next morning on Ex-Dividend date when I notice my cash balance has changed. Checking the Time Value of the option showed the Time Value was larger than the dividend to be captured. The assignment was to my advantage since I could then use the new cash for an additional investment in the same cycle.

Mario

• Alan Ellman September 1, 2018 8:10 am #

Mario,

Excellent observations. Although it does not make sense for an investor to exercise to capture a dividend, it will occur from time-to-time so retail investors must factor in this possibility if share retention is a priority.

Alan