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