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Mechanics of Exercising a Call to Collect a Dividend

Filed Under Beginner Options Trading 

Put Options
Hopefully you’re now convinced that exercising a call option early is not a healthy decision for your account. However, the opposite may be true for put options. For puts, if the stock is sufficiently in-the-money, then it does make sense to exercise early. Why the difference between calls and puts? When you exercise a call, you receive the risky stock and give up the secure cash. With puts, however, you get rid of the risky stock and receive cash. It’s the opposite set of transactions, so it has the opposite characteristics.
 
Imagine that you are holding stock along with a $50 put that you bought as insurance. The stock is now $35 and you see no hopes of it moving above $50 before expiration. If you did, you’d be better off holding the stock hoping that it shoots above $50 and letting the put expire worthless. But if you don’t see the possibility, then you have two choices: Exercise now and collect the money or exercise at expiration and collect the money. Obviously, take the money now. What stock price is satisfactory for early exercise? Mathematically, it will occur where the delta equals one, where the put is gaining dollar-for-dollar with each fall in the stock’s price. Of course, this doesn’t mean you must wait for the delta to equal one in order to exercise, but it should serve as a precautionary check. Even though you may not think that the stock has a chance of coming back, the delta may reflect something different. Delaying the exercise of a put only costs you the interest that you could have earned on the cash; you will always be able to get the strike price no matter how long you wait. And if interest rates are low, there’s not much of an advantage to exercising the put early. So if you’re in doubt about exercising the put option early, check the delta. If it’s not close to one (say 95 or higher), then you’re probably better off waiting.
 
For example, assume you are holding 100 shares of stock plus a $50 put with three months to expiration. The stock has fallen to $45 and your broker pays you 3% on cash balances. You decide to exercise early, sell your stock and take the $5,000 today, which will then earn interest and grow to $5,037 in three months. However, at a later time, the stock is trading for $51, which means you would have been better off holding the stock and letting the put expire worthless. In fact, we can even calculate a breakeven point for the decision. If the best you can do is $5,037 in three months with the cash, where does the stock’s price need to be at expiration to make the two choices equal? It needs to be at $50.37. At a stock price of $50.37, the $50 put is worthless and we can sell the stock for $5,037, which is exactly what we’d have from exercising early and earning interest. If you think the stock has a decent chance of rising to $50.37 by expiration, you’re probably better off to not exercise the put. Remember, you will always be able to get the $5,000 by exercising the put. The only difference is that you may collect something less than the $37 of interest if you delay your decision, which should obviously not be a critical point. On the other hand, if interest rates are high and you have 20 $100 puts, then that’s a different story. Just always be aware what the tradeoffs are and make your choices appropriately.
 
We’ve shown that exercising a call option early is never to your advantage with the exception of collecting a dividend. If that’s true, then why are so many traders tempted to do so? It is usually the result of strong desire to pay a low price for the stock that is trading relatively high above the strike. For example, if a hot stock is suddenly trading for $65 and you’re holding the $50 call, it just seems like you should take advantage of that “deal” before the stock falls. And it’s that mindset that causes traders to buy the stock while not realizing exactly what happened in the exchange. If you want to buy the stock, you can either pay $65 or pay $50 by exercising the call. The higher the stock price is above the strike, the better the deal. So once the stock seems to be getting relatively high, many traders erroneously think they had better exercise to take maximum advantage of the call option. But they never realize that they just increased the downside risk – and paid money to do so. Even with something as simple as exercising a call, traders can stumble in making the right decision. This is why it is so important to understand profit and loss diagrams, the price behavior of options, and market mechanics if you’re going to get involved in options. What appears to be a simple decision can easily be clouded by a number of factors that are not so easy to see.
 
There are many persistent myths in options trading. They survive because many of the technicalities seem so obvious that it’s hard to change our perception. Early exercise is perhaps one of the most difficult viewpoints to shake. Hopefully, this section has changed your perception.
 
Mechanics of Exercising a Call to Collect a Dividend
We previously learned that it is not optimal to exercise a call option early in order to gain the stock with the exception of collecting a dividend.
 
If you wish to collect a dividend you must exercise the call to gain control of the stock and only then can you get the dividend. However, you cannot just exercise it at any time and be assured of getting the dividend. The reason is that the dividend is only paid to those stock holders as of a specific date called the record date. If you are the owner of stock after the record date, you will not receive the dividend. For this reason, it is important to understand the mechanics of how dividends are paid and when to exercise the call option if you should decide to collect a dividend.
 
As with any exercise of a call, you do not want to exercise it any earlier than you must, and this standard still applies when exercising to get the dividend. Exercise too early and you’ll expose yourself to unnecessary downside risk. At the same time, if you exercise too late, you will miss out on the dividend. The key to collecting the dividend is to exercise the option on the correct date. In order to understand when that correct date is, you must understand the ex-dividend date.
 
What Is the Ex-Dividend Date?
The ex-dividend date, also called the ex-date, is the date the stock trades without the dividend. Just remember that “ex” means “without” and you will not be prone to one of the most common mistakes made by investors and brokers.
 
For example, let’s say a stock is about to pay a dividend and the ex-date is June 8. If you buy the stock on June 8 or later, you will not get the dividend. Remember, “ex” means without. If you buy the stock on the ex-date (or later), you are buying the stock without that dividend. On the other hand, if you buy the stock on June 7 (or earlier) you will get the dividend. On the flip side, if you sell stock on the ex-date or later, you will get the dividend. If you sell stock before the ex-date, you will not collect it. If investors would just focus on the ex-date, it is very easy to determine who gets the dividend and who does not.
 
Why Is There So Much Confusion in Practice?
Although it appears to be an easy task to figure out who gets the dividend, many investors find that it’s not so easy. Many times they buy the stock in anticipation of the dividend only to find that they are not entitled to it. The reason for the confusion is that when a dividend is announced, there are usually three dates associated with it:
 
·         Record date
·         Payable date
·         Ex-date
 
Corporations usually only publicize the record date and payable date in newspapers, financial websites, and television shows. The record date is the only date that matters to the company. Before the company pays the dividend, they look up a list of names of all investors who are owners of their stock as of the record date and pay the dividends to those names. Using the previous example, if a company announces a June 10 record date and your name is on the list, then you get the dividend. The payable date is when the payment is actually made, which may be a week or more after the record date. They may announce, for example, that they will pay a 20-cent dividend to all stock holders as of record of June 10 and payable on June 15.
 
Here’s where the confusion sets in for most investors… 
 
In order to be the owner of record, the stock transaction must be settled by the record date. There is currently a three-business-day settlement period, which is also called “T+3” settlement and stands for “trade date plus three business days.” In order to find the settlement date, you just add three full business days to your purchase date, not counting the trade date. For instance, if you buy stock on Monday, it will settle on Thursday since Thursday is three full business days from the trade date (assuming none of the days in between are holidays). If you buy stock Wednesday, it will settle on Monday.
 

To be continued……

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