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Early exercise of options

Early exercise of American calls for dividends

This page sets out some typical rules which are employed in the early exercise of an option. However this is not to be construed as advice in any specific case, and you should seek your own independent advice before making any decisions.

Summary

The following table sets out the rule of thumb for when an American call option is likely to be exercised ahead of expiry, before the stock goes ex-dividend.

Call option Put option (same strike) Exercise likely when
In-the-money zero value dividend > interest expense of buying shares early 
In-the-money value > 0 dividend > put price + interest expense of buying shares early

Where a call option is deep-in-the-money, with little chance of the stock falling below the strike price before expiry, the option is a candidate for early exercise.

This generally occurs where the dividend the investor would receive, if they were to exercise the call, is greater than the interest expense incurred in buying the shares which are the subject of the option ahead of the expiry date. Generally this only occurs on the day before the ex-dividend date.

For in-the-money calls where the corresponding put still has some value, the rule used by most of the market is that if the value of the dividend is more than the value of the corresponding put plus interest, then the call should generally be exercised for the dividend.

Writers of call options who want to avoid assignment (being exercised against) may need to either buy back or roll that short call position to another strike in another expiry, being mindful again that the option they roll to is not also a candidate for early exercise.

Examples

National Australia Bank 
Ex-Div 7th June 2004
Dividend 83 cents
Share Price $30.31 on last cum dividend date

1. June 2600 Call (deep-in-the-money)

  • Corresponding put is worthless
  • Interest = 6.4 cents (Strike Price $26.00 X Interest Rate 5.25%) / 365 days X 17 days till expiry
  •  83 cents > 6.4 cents

Therefore the June 2600 call will generally be exercised

2. June 3000 Call (In-the-money)

  • Corresponding put is 68 cents
  • Interest = 7.3 cents
  • 83 cents > 75.3

Therefore the June 3000 call will generally be exercised

3. June 3050 Call (In-the-money)

  • Corresponding put is $1.09
  • Interest = 7.5 cents
  • 83 cents < $1.165

Therefore the June 3050 call will generally not be exercised because the dividend isn't large enough.

Early exercise of American puts for interest

The following table sets out the rule of thumb for when an in-the-money American put option is likely to be exercised ahead of expiry.

Put option Exercise likely when
In-the-money Interest expense of holding the shares until expiry > corresponding call price

When put options are deep-in-the-money they become candidates for early exercise. 

Consider an example where an investor owns both stock and a put option over the same stock, and the put is trading at intrinsic value (as is often the case when the option is deep in the money). By exercising early, the holder of the put sells their shares at the exercise price of the option and earns interest on the proceeds earlier than if they were to wait until expiry to exercise. This usually occurs after the stock has gone ex-dividend, so that the dividend is retained by the shareholder.

Another way of looking at whether the put should be exercised early is to compare the value of the corresponding call option with the cost of carrying the underlying stock to expiry. The importance of this relationship is due to the fact that stock ownership plus a long put is an equivalent position to holding a call option with the same strike price and expiry. The two strategies are said to be synthetically equivalent. 

Both positions, stock and long put (S+P), and the long call (+C), profit if the stock goes up and limit losses if it falls. Therefore, if one can in effect exchange the synthetic position (S+P) for its equivalent (+C), and the cost of doing so (ie. the cost of the call) is less than the interest earned on the funds received from selling the stock, the early exercise of the put is worthwhile.

This simple arbitrage relationship is known as put/call parity, and is the fundamental relationship of option pricing. It is also the reason that mispricing between call and put options with the same strike and expiry is rarely found. Such mispricing offers the opportunity for arbitrage, where pricing differences are exploited at little or no risk to the trader, in the process forcing prices back to put/call parity.

Examples

National Australia Bank 
Share Price $28.00
Interest Rate 5.25%
7 days till expiry

1. 3400 Put (deep-in-the-money)

  • Corresponding call is worthless
  • Interest = 3.42 cents (Strike Price $34.00 X Interest Rate 5.25%) / 365 days X 7 days till expiry
  • 3.42 cents > 0

Therefore the 3400 put will generally be exercised early.

2. 3000 Put (In-the-money)

  • Corresponding call is 5 cents
  • Interest = 3.02 cents
  • 3.02 cents < 5 cents

Therefore the 3000 put will generally not be exercised early.

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