Covered call writing obligates us to sell our shares to the option buyer at any time up to 4PM ET on expiration Friday should the buyer choose to exercise those options. That is the definition of American Style options, the type we are dealing with when selling options against stocks and ETFs.  The buyer is in control unless we buy back the option. Now, we may not want our shares sold and there is so much we can do to prevent exercise from occurring but it is one of the risks we are exposed to as covered call writers. For those of us trading in sheltered accounts, exercise risk is miniscule. For investors trading in non-sheltered accounts there may be tax consequences. It is important to understand all the pros and cons of any investment strategy we are using and to discuss tax issues with our tax advisors.

On February 7th, 2014, Alex wrote me about the following trade he executed (I will reduce to 1-contract statistics):

Buy 100 x AAPL @ $502

Sell 1 x February $510 call

Stock price currently @ $520

Alex felt that early exercise was imminent and wanted to roll up to retain his shares. His other concern was that because AAPL was experiencing volatility, it would result in a lot of “buying and selling” during the current contract.

Let’s for a moment change hats and take the position of the option buyer who holds a call contract giving him (her) the right but not the obligation to purchase AAPL @ $510. At the time, AAPL was trading @ $519.68.

Credit for early exercise:

Buy AAPL @ $510

Sell AAPL @ $519.68

Credit = $9.68

 

Credit for selling the option:

Here is the options chain at the time I am writing this article:

 

The published bid = $13.55, $387 per contract more than taking the route of early exercise. Any educated option buyer would not take the route of early exercise. The key point to takeaway is that early exercise captures intrinsic value only, whereas selling the option also captures time value.

Aside from the option buyer doing the wrong thing, there is one exception to this rule. When there is a dividend distribution, it may make sense for the option holder to exercise early. If the dividend about to be distributed is greater than the time value remaining on the option premium it is possible that early exercise will occur…not guaranteed. When this does occur, it will take place the day before the ex-dividend date (date you must own the shares to benefit from the dividend distribution). To avoid this small chance of early exercise we must check this ex-date and buy back (or roll) the option prior to the ex-date. I checked the ex-date when Alex wrote me and, as it turned out, it was on February 6th, the day prior to his email so this was a non-factor.

Summary:

Early exercise is very rare but possible. The main reason it will occur is investor error or dividend distribution. Understanding the relationship between option time value and dividend amount along with knowing the ex-dates will generally avoid early exercise. Although small, the risk will always exist for early exercise.

List of “banned stocks”

In our BCI methodology, we avoid companies that report same store retail sales on a monthly basis. We refer to these companies as “banned” from consideration in our BCI methodology because of the volatility surrounding these reports and the possibility of a disappointment and share depreciation. Over the years, that list has had expanded to as many as 80 stocks. In the past few years companies have been opting out of reporting on a monthly basis like it was the plague and that list has diminished to under 10 (we are still researching to see if there are any companies that should be added to the list below). We have updated this list on this website which now includes the following stocks:

• BKE 
• CATO 
• COST 
• GPS 
• LB 
• SMRT 
• WAG 
• ZUMZ

When next month’s reports are made public, we will update the list, if needed, and inform our members.

Next live seminars: Southeast Florida

• Delray: March 18th
• Fort Lauderdale: March 19th

Here is the link for more information:

http://www.aaii.com/localchapters/pdfs/Southeast%20Florida%20140318.pdf

 

Market tone:

This was a very light week for economic reports and the ones that did come out reflected the impact that the extreme weather had as consumers stayed home and spent more money on utility bills and less on everything else:

• Business inventories (a report of the dollar value of product inventories held by manufacturers, wholesalers, and retailers. Included in the report is the inventories/sales ratio, a gauge of the number of months it would take to deplete existing inventories at the current rate of sales, which is an important indicator of the near-term direction of production activity) increased by 0.4% in January for the 8th straight month
• Initial jobless claims for the week ending March 8th came in @ 315,000 below the 330,000 economists were anticipating
• Retail sales rose by 0.3% in February after 2 straight monthly declines. Analysts were expecting a rise of 0.2%. However, sales were up only 1.5% year-to-year, the lowest increase since November, 2009
• The Producer Price Index (PPI- a measure of the average change over time in the selling prices of a fixed basket of goods by stage of production, industry, and commodity. It is considered a leading indicator for consumer inflation. The “core” PPI excludes food and energy prices—which account for roughly one-quarter of the broad PPI and tend to fluctuate widely—providing a truer reflection of inflationary trends) fell by 0.1% in February signaling low inflation and possible weakening demand in the economy. An increase by 0.2% was expected by economists
• Demand for services fell by 0.3% in February

For the week, the S&P 500 fell by 2%, for a year-to-date return of 0.1%, including dividends.

Summary:

IBD: Uptrend under pressure

BCI: This site is cautiously bullish but because of geo-political events (Ukraine) and concerns regarding globalization (China), we are favoring in-the-money strikes 3-to-2. Our expectation that this bearish stance will not last long.

I am really excited about my upcoming seminars in Fort Lauderdale and Delray this week. Hope to see many of you there.

My best,

Alan ([email protected])

www.thebluecollarinvestor.com