by Mike Scanlin

Is It Better To Exercise A Call Option Or Sell It Before The Ex-Dividend Date?

Investors who sell covered calls on dividend paying stocks are always concerned about early exercise. They are worried that the option holder will exercise the day before the ex-div date so that they (the option holder) will get the dividend instead of the investor who sold the covered call.

In reality, this only happens for 1 of 2 reasons: (1) there is no time premium left in the option (expiration date is very near the ex-div date, and/or strike is very deep in-the-money), or (2) the option holder is acting irrational (not in his economic best interest) because he forfeits any remaining time premium when he exercises; he’s always better off (economically) selling the call option instead of exercising it.

But it may also depend on things like transaction costs (commissions), the size of the bid-ask spread (for the option and the stock), and the likelihood of being filled at the midpoint.

Example Of A Call Option Before An Ex-Dividend Date

First thing to realize is that stocks and options don’t have 1 price; they have 2: a bid and an ask. If you are going to buy something you pay the ask; when selling it you receive the bid. In both cases you can do better with a limit order at the midpoint, which we will assume you are doing.

Imagine today is Tuesday and XZY stock has a bid-ask spread of 51.50 x 51.60 (so 10 cent spread). If you want to buy XZY you’d pay $51.60 and if selling it you’d receive $51.50. We will assume you can buy or sell at the midpoint, $51.55.

Now imagine you’ve sold a 50-strike call that expires on Friday. The current bid-ask for the call option is 1.60 x 1.70 (you’d pay $1.70 to buy it, and receive $1.60 if you sold it; we will assume you can do either at the midpoint of $1.65).

And, finally, imagine that XYZ goes ex-div tomorrow (Wed) for 30 cents/share. If it closes at 51.50 x 51.60 today, it should open tomorrow (on the ex-div date) adjusted down 30 cents for the dividend, so 51.20 x 51.30 (midpoint $51.25).

What Should The Option Holder Do?

Let’s look at the option holder’s economics for two scenarios: (1) sell the option, or (2) exercise the option today, collect the dividend, and sell the stock tomorrow (on the ex-div date).

(1) Selling The Option

Pretty straightforward: the midpoint is 1.65 so he sells it and collects $165 minus 1 option commission.

(2) Exercising The Option

He tells his broker he wants to exercise today. He pays $5000 (strike price times 100), collects $30 in dividends, and then sells the stock tomorrow, receiving the midpoint of $51.25. His net cash is 5125 + 30 – 5000, or $155 minus a couple of commissions.

So, Which Is Better? $165 Less 1 Option Commission, Or $155 Less 2 Commissions?

The option holder is better off selling the call when compared to exercising it and selling the stock the next day. If he really likes the company and wants to own the shares then he’s better off selling the option today and buying the shares. He will come out $10 better (plus a couple of commissions).

Why?

Because of time premium. This option doesn’t have much time premium, but what it does have he forfeits when he exercises.

Calculating Time Premium

An option’s price is made up of two parts: intrinsic value and time premium, calculated like this for an in-the-money option:

  intrinsic_value = stock_price - call_strike
  time_premium = call_price - intrinsic_value

In our example, the day before ex-div:

  intrinsic_value = 51.55 - 50.00 = 1.55
  time_premium = 1.65 - 1.55 = 0.10

So, he’s giving up 10 cents per share in time premium when he exercises. That’s the source of the $10 difference in his two choices ($165 vs $155).

What If You Can’t Get Filled At The Midpoint?

Sometimes markets are less actively traded and you can’t get filled at the midpoint. Let’s look at the extreme case where you use market orders for everything.

With market orders, if you sell the option you receive the bid, which is 1.60, so the option holder gets $160 (less one commission).

If he exercises, then he pays $5000, gets the $30 dividend, and sells the stock the next morning, receiving the stock’s bid of 51.20, and his net gain is: 5120 + 30 - 5000, or $150.

The difference between the two choices is still $10, but by not using limit orders he’s $5 worse off in both cases ($160 or $150 with market orders, vs $165 or $155 with midpoint limit orders).

Not All Option Holders Are Rational

Some option holders, who haven’t worked through this math, believe the fallacy “you should exercise if the amount of the dividend is larger than the time premium remaining”. This is based on their assumption that the stock’s price won’t be adjusted down by the amount of the dividend on the morning of ex-div.

But if that happens then it’s like the stock opening up from the prior day’s close, which can happen at any time irrespective of any dividends. They made their money by holding a stock overnight that opened up (compared to prior day’s closing price); which you could do with a non-dividend-paying stock, too. “Opening up” and “collecting a dividend” are two separate things.

If a stock closes at 51.55, pays a 30-cent dividend, and then opens up on ex-dividend day at the same 51.55 price then the stock has opened up 30 cents. You could have a different company close at 21.40 and open at 21.70 (with no dividend in between). Same thing. Both stocks opened up 30 cents from the prior day’s close.

Selling The Option Is Better Than Exercising

Basically, if there is even 1 penny of time premium remaining in the option, the option holder is better off selling the option than exercising it. Having said that, we see early exercise to capture dividends (with options that have non-zero time premium remaining) all the time. The world is insane (or at least some of its participants are not acting in their economic best interest).

Mike Scanlin is the founder of Born To Sell and has been writing covered calls for a long time.