Welcome back to my series on early exercise! Today's images all spring from one of my favorite board games, Clue, because today I'm going to tip you off to a few tell-tale signals that help you determine if your short option position is more or less at risk for early exercise. 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 early exercise really happens. Bottom line: it's more often than you might realize.)
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 up 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 applies -- and still your short option gets assigned. The only way to assure that you will not be assigned is to buy to close the position and remove your obligation. Keep this in mind as you read on.
Risk factors for early exercise: 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 then if they just bought the stock in the current marketplace. As the saying goes: Why pay more?
Time to expiration
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 call has a strike BELOW the current stock price.)
Usually it's more beneficial for the buyer just to sell the option in the open marketplace, capturing that time value in the process. If the buyer were to exercise the call and then sell the actual stock, that excess time value in the options premium is lost. ("Time value" refers to the amount of premium in the option's price above the intrinsic value, i.e. how much the option is in-the-money. Time value plus intrisinic value = total options premium.)
Time Value of Money
This is similar to the section we just finished, but different enough that it bears mentioning. In addition to the benefit of capturing time value by selling the option (versus exercising it), if you think about what happens when you exercise a call there's another reason 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, then why not wait until later to do so? The only quantifiable reason to exercise a call and spend the cash NOW is to capture an upcoming dividend on the stock...leading to my next factor, dividends.
Dividends
Stay aware of your underlying stock's dividend schedule when you go short on call options, especially the ex-dividend date. Many option buyers are enticed to exercise 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 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 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.
(Disclaimer: In rare instances where the dividend is extremely large - like MSFT's dividend last year - strikes will get altered.)
Risk factors for early exercise: short puts
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. (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 to expiration
Pretty much the same story for puts as described for calls above. 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 value.
Time Value of Money
This situation here works a little differently for puts than for calls. Puts may be MORE likely 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 bring 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 the right time, put buyers may occasionally take this route and exercise early.
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 value. But as expiration fast approaches, the time value of the put becomes a smaller and smaller part of the total ITM put price -- and the odds of early exercise start to increase.
Next up: math! (But not too much.)
Well, that covers the general conditions that might up the chances of early exercise.
In my next post we'll get into the math that determines when to exercise. In addition to what we've just covered, many option buyers use certain synthetic relationships and the cost-to-carry to decide when conditions are right to exercise. I'll show you a few calculations to make that decision clearer from the buyer's perspective -- which makes you that much more ready to act as a seller if you're assigned.
Regards,
Brian (OG)
[images:
Games - Clue 1979 by board game pieces on flickr
"I Suspect....." by Lily White on flickr
Clue board game logo and characters copyright Parker Brothers / Hasbro]
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities.
