Dividends and Early Exercise
As the ex-date approaches, in-the-money (ITM) calls on equity options can
often be found trading at parity, regardless of the dividend amount and
regardless of how far off expiration is. This seems counterintuitive. What
about interest? What about dividends? Normally, these come into play in
option valuation.
But option models designed for American options take the possibility of
early exercise into account. It is possible to exercise American-style calls
and exchange them for the underlying stock. This would give traders, now
stockholders, the right to the dividend—a right for which they would not be
eligible as call holders. Because of the impending dividend, the call
becomes an exercise just before the ex-date. For this reason, the call can
trade for parity before the ex-date.
Let’s look at an example of a reversal on a $70 stock that pays a $0.40
dividend. The options in this reversal have 24 days until expiration, which
makes the interest on the 60 strike roughly $0.20, given a 5 percent interest
rate. The day before the ex-date, a trader has the following position at the
stated prices:
Short 100 shares at $70
Long one 60 call at 10.00
Short one 60 put at 0.05
To understand how American calls work just before the ex-date, it is
helpful first to consider what happens if the trader holds the position until
the ex-date. Making the assumption that the stock is unchanged on the ex-
dividend date, it will open at $69.60, lower by the amount of the dividend—
in this case, $0.40. The put, being so far out-of-the-money (OTM) as to
have a negligible delta, will remain unchanged. But what about the call?
With no dividend left in the stock, the put call-parity states
In this case,