Before examining the considerations, we first need to understand the mechanics of call options and the dividend process. Dividends are payments by a company to shareholders of record. These payments may be regular, predictable, variable or even one-time events. Some industries, like tanker or mining companies, pay highly variable dividends based on profitability while others pay a one-time dividend.
Option holders need to pay close attention to the declaration date; the date when the board of directors publicly announces when it will pay a dividend. This date should serve to place the option holder on notice to analyze the costs, benefits and risks associated with exercise. The ex-dividend date is the first day that the underlying security will trade without the announced dividend. Therefore, the long call option holder must exercise one day prior to this date in order to receive the dividend.
It is also critical that the option holder understand the rights associated with a long call position. Options are designated as either American or European style. European style options can only be exercised at expiration, and accordingly, the option seller may not be assigned prior to the expiration date.
American style options allow the holder to exercise any time prior to expiration while the call seller may be assigned any time prior to the expiration date. Sellers of call options, when assigned prior to the ex-date, will pay the dividend. All stock options are American style exercise and therefore, will be the focus of this discussion. Note that the popular S&P TSX 60 (SXO) is an index and its corresponding options are European style.
A quick lesson on call option value can be stated as:
Total Option Value = Intrinsic Value + Time Premium.
Time premium is comprised of Interest Rate Value + (Volatility Value – Dividend Value).
Increases to the intrinsic value, interest rates and volatility all contribute to increases in call option value. The volatility value, or time value is any premium in excess of intrinsic value. Increases in dividends have the inverse affect in that they decrease call option value; this is true because it is more desirable to hold the stock rather than the call option as only shareholders are entitled to the dividend.
The determination to exercise or not must be weighed with all the benefits and costs taken into account. This will require additional homework by the investor. Let’s examine the factors that help the investor make the correct decision.
One key variable that must be noted is that the stock will lose value by the amount of the dividend on the ex-date. Let’s suppose the dividend is 30 cents. You can expect the stock to decline by this amount. There is an obvious incentive to exercise to avoid suffering a net 30 cent loss because the dividend proceeds (30 cents) would offset the decline in stock price. This decision would be an easy one if not for the fact that the option may have premium over and above its intrinsic worth. The time value will be lost upon exercise.
Let’s look at an example:
The long call has 50 cents of premium over and above its intrinsic value; therefore 15 cents will be gained from exercising the call and capturing the dividend, the stock price will decline by 15 cents and the premium lost from exercising the call option will be 50 cents. Clearly not an optimal time to exercise!
The most obvious time to exercise is when the call option is at parity, so there is no loss due to time-value forfeiture. One easy way to check if your call option is at parity is to check the corresponding put option; it should have no value, or at least, no bid.
The option exerciser avoids a 15 cent loss on the decline of the stock price without sacrificing any excess premium value.
While we examined the math we have yet to weigh the additional costs associated with exercise. When you exercise a call option, you pay a commission and you become long stock. There is a cost to carry this stock and you must either pay for it in full or margin it. The investor that does not have the funds to do either may want to sell the call option and close out the position. In addition, long stock means you no longer hold a limited risk long call option and, you have changed your risk profile by virtue of the exercise.
Let’s establish some simple guidelines for when you might consider exercising.
Conversely, one should not exercise when:
One final note, dividends in general are taxed at a lower rate than interest income. The federal dividend tax credit along with any provincial tax credits may provide the Canadian investor with additional advantages and must also weigh into the exercise calculus. For further information on fiscality of options, please refer to the Montréal Exchange’s Equity Options Tax Regime
Grigoletto Financial Consulting
Alan Grigoletto is CEO of Grigoletto Financial Consulting. He is a business development expert for elite individuals and financial groups. He has authored financial articles of interest for the Canadian exchanges, broker dealer and advisory communities as well as having written and published educational materials for audiences in U.S., Italy and Canada. In his prior role he served as Vice President of the Options Clearing Corporation and head of education for the Options Industry Council. Preceding OIC, Mr. Grigoletto served as the Senior Vice President of Business Development and Marketing for the Boston Options Exchange (BOX). Before his stint at BOX, Mr. Grigoletto was a founding partner at the investment advisory firm of Chicago Analytic Capital Management. He has more than 35 years of expertise in trading and investments as an options market maker, stock specialist, institutional trader, portfolio manager and educator. Mr. Grigoletto was formerly the portfolio manager for both the S&P 500 and MidCap 400 portfolios at Hull Transaction Services, a market-neutral arbitrage fund. He has considerable expertise in portfolio risk management as well as strong analytical skills in equity and equity-related (derivative) instruments. Mr. Grigoletto received his degree in Finance from the University of Miami and has served as Chairman of the STA Derivatives Committee. In addition, He is a steering committee member for the Futures Industry Association, a regular guest speaker at universities, the Securities Exchange Commission, CFTC, House Financial Services Committee and IRS.