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)

Premium Stock report Ex-Date Location

early exercise and Dividend Cature

ODFL_ Ex-Date

ODFL_Ex_Date_Close

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

covered call writing and dividends

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)

THE WEEK AHEAD

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