I have received several questions recently about early exercise of in-the-money covered calls. It seems that some covered calls investors are overly concerned that stocks they want to continue to hold will be called away from them on the day prior to an ex-dividend date if the stock price is even only slightly above the strike price.
There is little likelihood of a stock being called away by Call options owners unless the option is at least moderately or more likely deep in-the-money (i.e. the stock is moderately or substantially higher than the strike price the day prior to ex-div). Let's consider my current position in Capital One Financial: Prior Post for COF Position as an example below.
Today was the ex-dividend date with a $.40 dividend per share of Capital One stock. At the market close yesterday, the price of COF was $87.54 and the strike price is $85.50.
What happened? NOTHING.
The Call owner could have exercised his options and purchased the stock at $85.50 (well below current market price) and also captured today's $.40/share dividend. So why didn't he/she exercise their option?
Instead of viewing it from our perspective (i.e. the Covered Calls owner's perspective), let's view it from the Call owners' perspective. The closing bid/ask price for these Call options was $2.07/$2.18. Using a midpoint price of $2.13, we calculate a time value remaining for the only 8 days until these Feb2017 options expire as $.09 = [$2.13 - ($87.54 - $85.50)]. If the price of COF were to open today unchanged from its $87.54 closing price yesterday, if would actually open at $87.14 instead since the ex-div amount is subtracted upon the market open on the ex-div date. So again, from the Call owners perspective, by not exercising they lose the opportunity to receive the $.40 dividend, however that is exactly offset if they had exercised by the $.40 loss in the market opening stock value for the stock they would have purchased. So in this Capital One example, the immediate effect of a Call owner exercising their option would have been a net loss of $.09/share time value. Granted $.09/share for 300 shares would have been only a loss to the Calls owner of $27.00 plus commission, but an immediate loss nevertheless that they avoided by not exercising in order to capture the dividend.
Because the $.09 is a small loss to take, some Call owners might have decided to exercise their options anyway in this case. As a covered calls investor, I can understand you not necessarily wanting to have your stock called away. However, I trade covered calls only in IRA accounts where my gains are protected from current year taxes. So in this case, since there is no short-term capital gains possibility, I welcome getting my shares called away early (the day prior to the ex-div date). This is because when I compare the annualized return-on-investment for early exercise against an alternative possibility of being in-the-money and my shares called away on the options expiration date, it is much more common that the early exercise provides a higher annualized return. Moreover, the idiom "a bird in the hand is worth two in the bush" also applies here since there is certainly some unwelcome possibility that the stock price will decline to below the strike price in the days until the options expiration date.
It is certainly not easy to fully understand the early exercise concept described above. Hopefully, you are now able to better understand the logic. If not, try re-reading it until you are comfortable in your understanding since it is an important concept for any covered calls position established where there is an ex-div date prior to the options expiration date.
As always, I welcome the opportunity to address anything on this topic further. Just email me at partlow@cox.net.
Best regards and Godspeed,
Jeff
