Option Exercise and Early Assignment - Part 2

optionsguy posted on 12/20/13 at 03:11 PM


Welcome back to my series on early exercise. Today I'm going to review a few tell-tale signals that help you determine if your short option position is more or less at risk for early assignment. If you keep an eye out for these clues, it could help you avoid getting blind-sighted.

(By the way, last week's post defined what early exercise is, explained how assignment works, and debunked some myths about how often options expire worthless, which is likely not as often as you might think.)

Background

In this article we are going to keep things simple and talk only about options on stocks. Index options are a topic for a later date. Also, this article mainly focuses on the short option holder and understanding why and when an assignment may occur.
 
When discussing the exercise of a call, assume the owner of the call would like to buy the stock. Similarly, when discussing the exercise of a put, assume the owner of the put would like to sell stock. So, for our purposes, there is a long call buyer who would not mind owning the stock, and if it makes sense, plans to exercise the call. And just the same, the owner of the put already owns the stock along with the put, and if it makes sense, plans to exercise the put as a means to sell the stock.
 
Options Buyers are Humans -- Not Machines
 
Let's start out with a caveat: ANYTIME you're short a stock option, you can be assigned. While the following quantitative factors may increase your chances of being assigned early, options buyers are humans, not machines -- and sometimes humans do things for not entirely rational reasons. The day may come where none of the following conditions apply, but your short option still gets assigned early. The only way to assure that you will not be assigned is to buy to close the position and remove your obligation. It’s something to always keep in mind.

Risk Factors for Early Assignment: Short Calls
 
Whether you're In-The-Money (ITM) or Out-of-The-Money (OTM)

It may sound obvious, but an OTM short option is less likely to get exercised than a short option that is ITM. (Keep in mind: an OTM call has a strike ABOVE the current stock price; an ITM call has its strike BELOW the current stock price.) Call buyers usually don't want to exercise to buy stock if the strike/purchase price for the stock would be higher than if they just bought the stock in the current marketplace. As the saying goes: Why pay more?

Time Value of Money

If you think about the movement of monies when you exercise a call, there's a logical reason for an owner not to exercise early. If the call buyer exercises, he or she has to come up with the cash to buy the stock at the strike price. That strike price or purchase price won't change throughout the life of the option; after all, that's the attraction to owning it. Exercising now means the call buyer has to spend cash now; exercising later (at expiration) means spending cash later. If you know what price you're definitely going to pay to buy the shares, then why not wait until later to do so?
 
Heck, the stock may even drop in price and end up below the strike price before the option expires if you give it time. The main benefit of owning a call option is the purchase price for the stock (ie. strike price) is known if you purchase the stock via an exercise. Once an owner exercises a call early that benefit is gone and the owner now has all the costs and risks of stock ownership.
 
Time Premium

In addition to the consideration of the time value of money in the call exercise decision, the call owner may also consider the benefit of capturing time premium by selling the option (versus exercising it). "Time premium" refers to the amount of premium in an ITM option's price above the intrinsic value, i.e. how much the option is in-the-money. (Time premium + intrinsic value = total price of an ITM option.)

Generally, if an option is ITM but still has some time premium in the option price, it usually doesn't make sense for the option buyer to exercise. Usually it's more beneficial for the buyer just to sell the option in the open marketplace, capturing that time value in the process. Once the call contract is sold to close it ceases to exist in the owners account. If the buyer were to exercise the right to buy the stock and then immediately sell the stock on the open market, that excess time value in the options price is lost.
 
With all this said - there is a quantifiable reason to exercise a call, spend the cash now and forgo the time premium to capture an upcoming dividend on the stock. This leads us to the next factor, dividends.

Dividends

Stay aware of your underlying stock's dividend schedule when you go short on call options, specifically the ex-dividend date. Many option buyers are enticed to exercise early to capture an upcoming dividend.

When a stock pays a dividend, the stock price decreases by the dividend amount on the ex-dividend date. For the call buyer (who is long that call) the strike price doesn't change at all, even though we all know the stock is going to decrease in price.

So if the call buyer plans to exercise anyway, why not do it the day before the ex-dividend date, become the stock owner on record and therefore entitled to receive the dividend? If the dividend being paid is larger than the time premium in the option contract, it may make sense to go this route. On the other hand, if the dividend is small many call buyers won't bother, especially if it's smaller than the call's current time premium.

Bottom line: keep your eye on dividends as early-exercise triggers, period, but pay especially close attention as expiration nears and if the dividend is likely to be large.

(One other thing to note: In rare instances where the dividend is especially large, the strikes may get altered to account for the special dividend.)

Risk Factors for Early Assignment: Short Puts

Whether you're In-The-Money (ITM) or Out-of-The-Money (OTM)

Stating again what may sound obvious, but an OTM short option is less likely to get exercised than a short option that is ITM. (For puts, OTM means the strike is BELOW the current stock price; ITM means the strike is ABOVE the current stock price.) Put owners usually don't want to exercise and sell a stock for less than they'd fetch in the open marketplace.

Time Value of Money

This situation here works a little differently for puts than for calls. Puts may be more likely to be exercised early compared to calls because of the time value of money. Think of it this way: if the put owner exercises early, he or she sells stock at the strike price and brings in cash. As anyone who's outspent their paycheck knows, sometimes getting cash now will trump getting cash later. Because exercising a put can bring in necessary cash at a needed time, put buyers may occasionally take this route and exercise early.

Even with that said, many times it's still a better idea for the buyer to sell that put in the open market to capture the excess time premium. But as expiration fast approaches, the time premium of the put becomes a smaller and smaller part of the total ITM put price -- and the odds of early exercise start to increase.

Time Premium

This is largely the same for puts as described above for calls. Generally, if an option is ITM but still has some time premium in the option price, it usually doesn't make sense for the option buyer to exercise. (Again, an ITM put has a strike ABOVE the current stock price.) The put buyer is usually better off selling the put in the open market and capturing that excess time premium.

Dividends

Concerning puts if a stock is about to go ex-dividend it is a deterrent for put option owners to exercise. If you think about the scenario we assumed at the beginning of this blog (the owner of the put also owns the stock). If the owner were to exercise early before the ex-dividend date they would be selling the stock, therefore not be owner of record and would not be entitled to receive the dividend.
 
Next up: Math! (But not too much.)

This has covered the general conditions that might increase the chances of early assignment.

In my next post, we'll get into the math that underlies when a call’s early exercise may make fiscal sense. In addition to what we've just covered, understanding certain synthetic relationships and how “cost-to-carry” is used in the pricing of puts and calls is crucial in helping to determine when an option may be an early exercise candidate. I'll show you a few calculations to make that decision clearer from the buyer's perspective, which can make you that much more ready to act as a seller if you're assigned.

Regards,
Brian (OG)

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Posted by optionsguy on 12/20/13 at 03:11 PM

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