The early exercise feature for equity options contain fundamental changes in risk that need to be evaluated prior to making a decision. The most common reason to exercise a call early is to capture a dividend. By exercising a call option the day before a stock goes ex-dividend the option holder take delivery of the stock and captures said dividend. This is can be an easy decision if options are deep in the money but how do you evaluate which strikes should be exercised?

Calls

The answer lies in understanding the risks that are inherent in the exercise decision. The call you own has “limited downside risk with unlimited upside potential”. By exercising the call and taking delivery of the shares you are now accepting “unlimited downside risk”. This unlimited downside risk potential is represented by the price at which the put with the same strike is trading. The primary component of the decision is comparing the amount of the dividend to the price of the put. (See formula below)
Interest is also a consideration. Interest and dividends normally have an inverse relationship. When you own stock you are paying, or at least forgoing earning, interest on the money used to purchase the stock. However by owning the stock you will collect the dividend. Conversely, if you have shorted a stock you may earn interest on the cash collected (depending on your broker) but are responsible for paying any dividends.

In our current low interest rate environment interest plays a diminished role but it is important to know the calculation to apply to longer term options and when interest rates are not as low in the future. The Cost to Carry (C of C) formula where i=current interest rate = 2%, 10 days to expiration, $25 strike. The example below shows a C of C of 1.4 cents, probably not significant but this is important to go through this process.
 

C of C = i x strike x # days to exp./360
$0.014 = 2% x 25 x 10/360
 

A call should be exercised when the dividend is greater than the interest expense plus the value of the put. To continue the example from above a stock going ex-dividend tomorrow that pays a $0.12 and the $25 put is valued at $0.05.

Exercise Call if Dividend > C of C + Put (same term and strike)
$0.12 > $0.014 + $0.05
 

To extend this example out we can check the call option for the same strike one month further out, 40 days to expiration, 2 % interest, $0.12 dividend and put valued at $0.15.

C of C = i x strike x # days to exp./360
$0.056 = 2% x 25 x 40/360

Exercise Call if Dividend > C of C + Put (same term and strike)
$0.12 < $0.056 + $.15
 

Puts

Puts are more straightforward in that you are usually considering exercising them after a dividend is paid. It is good practice to go through the full calculation for each decision. The same factors apply but just like the call exercise decision it is important to understand the new risks you are taking on with the exercise decision. The put you own has “limited upside exposure and unlimited downside potential”. When exercised this position becomes short stock which has “unlimited upside risk” and is required to pay dividends. In the case of exercising a put interest is considered a positive and dividends are considered a negative.

A put is in exercise when the interest earned is greater than the dividend plus the call. The day after the dividend is paid in our example above you should be trying to determine if any of the deep in the money puts should be exercised. With 9 days to go the 30 call has no value and there is no dividend. From a purely mathematical standpoint the put is in exercise, it is up to you if capturing 1.8 cents makes sense from a commissions and effort standpoint.
 

C of C = i x strike x # days to exp./360
$0.018 = 2% x 35 x 9/360

Exercise Put if Interest > Dividend + Call (same term and strike)
$0.018 > $0.0 + $0.0
 

Extending this concept out to the next month assume that the dividends are paid quarterly and that there will be no dividend within the following months expiration.

C of C = i x strike x # days to exp./360
$0.076 = 2% x 35 x 39/360

Exercise Put if Interest > Dividend + Call (same term and strike)
$0.076> $0.0 + $0.05

Once again from a purely mathematical standpoint the put is in exercise. Depending on your risk profile you may not want execute this trade.

Conclusion

Understanding the risks that are inherent with an exercise decision is important. Particularly when the decision effects positions with a significant time component. There is a fundamental change is risks associated with your position which needs to evaluated properly. Going through the calculation exercises shown above will provide and more complete understanding of how your option’s increased value is being derived.

Dave Rodgers, Contributor