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