Before the ex-date, the model valued the call at parity. Now it values the
same call at $0.25 over parity (9.85 − [69.60 − 60]). Another way to look at
this is that the time value of the call is now made up of the interest plus the
put premium. Either way, that’s a gain of $0.25 on the call. That sounds
good, but because the trader is short stock, if he hasn’t exercised, he will
owe the $0.40 dividend—a net loss of $0.15. The new position will be
Short 100 shares at $69.60
Owe $0.40 dividend
Long one 60 call at 9.85
Short one 60 put at 0.05
At the end of the trading day before the ex-date, this trader must exercise
the call to capture the dividend. By doing so, he closes two legs of the trade
—the call and the stock. The $10 call premium is forfeited, the stock that is
short at $70 is bought at $60 (from the call exercise) for a $10 profit. The
transaction leads to neither a profit nor a loss. The purpose of exercising is
to avoid the $0.15 loss ($0.25 gain in call time value minus the $0.40 loss in
dividends owed).
The other way the trader could achieve the same ends is to sell the long
call and buy in the short stock. This is tactically undesirable because the
trader may have to sell the bid in the call and buy the offer in the stock.
Furthermore, when legging a trade in this manner, there is the risk of
slippage. If the call is sold first, the stock can move before the trader has a
chance to buy it at the necessary price. It is generally better and less risky to
exercise the call rather than leg out of the trade.
In this transaction, the trader begins with a fairly flat position (short
stock/long synthetic stock) and ends with a short put that is significantly
out-of-the-money. For all intents and purposes, exercising the call in this
trade is like synthetically selling the put. But at what price? In this case, it’s
$0.15. This again is the cost benefit of saving $0.40 by avoiding the
dividend obligation versus the $0.25 gain in call time value. Exercising the
call is effectively like selling the put at 0.15 in this example. If the dividend
is lower or the interest is higher, it may not be worth it to the trader to
exercise the call to capture the dividend. How do traders know if their calls
should be exercised?