20 Part I: Basic Properties ol Stoclc Options 1. Buy the January 40 call at 9.80. 2. Sell short XYZ common stock at 50. 3. Exercise the call to buy XYZ at 40. The arbitrageur makes 10 points from the short sale of XYZ (steps 2 and 3), from which he deducts the 9.80 points he paid for the call. Thus, his total gain is 20 cents - the amount of the discount. Since he pays only a minimal commission, this trans- action results in a net profit. ' Also, if the writer can expect assignment when the option has no time value pre­ mium left in it, then conversely the option will usually not be called if time premium is left in it. Example: Prior to the expiration date, XYZ is trading at 50½, and the January 50 call is trading at 1. The call is not necessarily in imminent danger of being called, since it still has half a point of time premium left. Time value Call Striking Stock = + premium price price price = 1 + 50 50½ = ½ Early Exercise Due to Dividends on the Underlying Stock. Some­ times the market conditions create a discount situation, and sometimes a large dividend gives rise to a discount. Since the stock price is almost invariably reduced by the amount of the dividend, the option price is also most likely reduced after the ex-dividend. Since the holder of a listed option does not receive the dividend, he may decide to sell the option in the secondary market before the ex-date in anticipation of the drop in price. If enough calls are sold because of the impending ex-dividend reduction, the option may come to parity or even to a discount. Once again, the arbitrageurs may move in to take advantage of the sit­ uation by buying these calls and exercising them. If assigned prior to the ex-date, the writer does not receive the dividend for he no longer owns the stock on the ex-date. Furthermore, if he receives an assignment notice on the ex-date, he must deliver the stock with the dividend. It is therefore very important for the writer to watch for discount situations on the day prior to the ex­ date.