Episode 118

To Early Exercise or Not, That is the Question

Articles From: Market Chameleon
Website: Market Chameleon

By:

Co-founder

Market Chameleon

Will McBride and Dmitry Pargamanik cofounders of Market Chameleon join IBKR’s Jeff Praissman to discuss the risks and benefits of early option exercises and assignments.

Summary – IBKR Podcasts Ep. 118

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Jeff

Hi everyone, welcome to IBKR podcasts. I’m your host, Jeff Praissman, and it’s my pleasure to welcome back the co-founders of Market Chameleon, Will McBride and Dmitry Pargamanik.

Hey guys, how are you? It’s great to have you back.

Dmitry

Hey, Jeff, thanks for having us.

Jeff

Oh, my pleasure. We just wrapped up a great webinar on early option exercises and we’re going to take this opportunity in the podcast studio to discuss further the topic. Links to the webinar if our listeners are interested are going to be in the viewing notes. So Will and Dmitry, there’s kind of a background, right? There are two types of options, American and European style.

So American can be exercised early while European style cannot have early exercises and assignments. So what we’re discussing really is going to only apply to the American style options which are really the majority of the options that trade on the major US exchanges anyway. And let’s kind of start with, before getting into specific reasons why calls or puts maybe exercised, could either of you give our listeners a quick overview on how options are used as risk management tools?

Dmitry

If you trade options any trader needs an effective risk management tool. Without it, it would be almost impossible to be successful in the long term. And when we talk about risk management tools, it’s not only to help you avoid unnecessary losses, but also to trade efficiently so you could optimize your returns. And one of the peak components to risk management tool is to allow you to assess when an option is an early exercise. It’s important to know if it’s a candidate for an early exercise and help you make that decision; should you exercise the call or should you exercise the put?

Jeff

So let’s start with calls, to give the owner the right to buy the stock, if exercised. What are some of the common reasons that a call position would be exercised early?

Dmitry

There could be many reasons potentially to exercise a call early. The most common is the dividend. You want to check if your call is an early exercise candidate right before the ex-dividend date.

And the reason for that is that if you’re a shareholder, a stockholder, you would be entitled to that dividend. The company issues dividends to the shareholders, but an option holder is not entitled to a regular dividend. And at that point, if you hold the option, you don’t exercise it. You don’t get the dividend and right before the ex-dividend date, you have to make a decision. Should I exercise this call or not?

And you really have to know if the option itself is a candidate for an early exercise because not all options are so you’d have to go through all the checks and make a decision. Should I exercise this call and if it is  a candidate for an early exercise and let’s say you don’t exercise that call, well, you lose out on that dividend.

Essentially you would have a similar risk profile, but you lose out on the dividend, which again, if you’re trying to trade efficiently, you want to optimize your returns and that’s why you need to know ahead of time and make that assessment.

Jeff

Not only losing out on the dividend, right, but the stock’s going to drop 50% when it pays that that dividend, right? So if the investor holds on to that call, it should be worth 50%, or $0.50 less in that case, correct? So not only are they not going to get the dividend, but they’ll lose money.

Dmitry

The stock will adjust by the amount of the dividend and the call will adjust accordingly. So you still have the right to buy the stock, but you no longer have the right to that. You cannot get that dividend that was paid out to the shareholders. So it’d be a missed opportunity.

Jeff

And besides a stock going X Div, are there any, and I know there are several reasons, are there any other more common reasons to exercise the call early, even if there was no dividend or had nothing to do with the going exit?(4:16)

Dmitry

Yeah, there could be other special reasons that exist. Maybe there’s a there’s a special deal going on that you’d want to exercise early, or a corporate action. Also, if a stock is hard to borrow, sometimes you may want to exercise that call and convert it to stock because if you own the stock, you could lend it out and potentially earn that lending fee.

So, if the stock is hard to borrow and you want to stay long on that stock, or you don’t mind staying long on that stock, you could potentially earn a yield on that stock. If you lend it out, that might be another consideration.

Jeff

So, is it the same reasons for puts which give the owners right to sell the stock? Or is there a different reason why a holder would exercise a put early?

Dmitry

There are different reasons for exercising a put. The most common reason is for the interest that you could earn on short stock. When you only deepen a money put, let’s say, there’s a difference and it’s basically a bet on the downside, right that the stock will fall. Similar to shorting the stock. But there’s a difference between owning a put and being short stock.

If you’re short stock, you borrow the stock, you sell it and when you sell it short, proceeds come into your account where you get the proceeds from selling it.

It comes into your account and that can earn interest in an interest-bearing account. Proceeds enter, you earn interest from the broker,  or by the Treasury but that can earn you interest.

If you’re long a put, it’s a net debit. You’re not earning interest on being long a put. It’s an opportunity caused by being long a put instead of short a stock.

So if you have a deep enough money put that acts very similar to just being short stock, there’s no time premium, let’s say, very deep into money, then you may want to do that analysis to see, “ Am I better off exercising the put, converting it to short stock or bringing in those proceeds to earn interest?

You still have the same position of being short. However, at that point, that account will start earning interest and you’d have to go through that analysis to see if it makes sense.

Jeff

Dmitry, you’ve discussed the reasons why an investor would exercise a call or put early, but even if the data you know points to it being the most efficient or “correct strategy”, are there reasons why an investor or trader wouldn’t want to exercise early?

Dmitry

Yes.

So when you exercise your option early, your call or your put, you do lose at that point the optionality. You no longer have the option to exercise. You give that up, it converts to stock, the option goes away, and you’re no longer protected at that strike.

So it is a decision you’d have to make and go through the analysis- a cost benefit analysis. Is it worth doing the exercise? Because once I convert that that option to stock, that option goes away. Now you either have a long or short position depending on the option that you exercise.

Jeff

What could be done about, well we’ve discussed in the prior questions, if you would definitely be leaving money on the table, or that call would drop in value if the dividend got paid and so on with the interest rates with the puts? Is there something that they could do to not leave all the profit on the table if they ended up not following the efficient strategy of exercising early?

Dmitry

And that’s a good question. If you exercise, let’s say a call in a certain strike, well you lose that ability to limit your risk to that strike, right?

So the stock drops, obviously you’re not limited to that strike any longer. And if you wanted to actually limit yourself on that strike, well, you could turn around and buy a put on that strike.

And that’s where the cost benefit analysis comes in. Where you say well, is the dividend that I’m going to receive large enough for me to exercise the call, protect myself on the strike by buying the put and still be left over?

Will I have enough left over to make economic sense? So you could go through that exercise and you don’t have to necessarily just exercise the call and be long stock because you’re receiving that dividend to use some of the proceeds to go and purchase a put. To protect you on that strike, right?

And that could also make sense where you don’t cash out on the total amount of the put, but only a portion of it. And same thing to exercising the put. When you exercise a put well, your short position is no longer limited to that strike. And if you do the analysis in the scenario, you’ll get 5 minutes to maintain a short position from now to that expiration. How much do I stand to make in the interest that I’m going to earn, and what would it cost me to buy a call to protect my upside in case the stock goes back up through that strike?

So there is an analysis you could do and other actions that you could take to at least benefit from some of the dividend or some of the interest and still create a synthetic to protect your risk.

Jeff

We’ve discussed some of the reasons why options are exercised early. You know, obviously if an investor or trader is short, they run the risk of being assigned early. I’m assuming that they need to look out for the exact same circumstances that the long holders looking for just to decide whether they’re at risk or not to make a judgment on how to handle it. But again, as we just discussed, it’s not always black and white.

An option may not be exercised early. So what are ways the other side of that, you just discussed the holder and how they kind of risk manage around it. What are ways the investor or trader that are short the option can risk manage around the uncertainty of being assigned because they have no control over whether they get assigned or not? Whereas the holder has control over whether they want to exercise.

Dmitry

Yeah, that’s exactly right. If you’re short the option, you cannot control getting assigned or not. So you can’t say don’t assign me, it’s always up to the owner of the option or the buyer of the option. They have the right and you’ll have the obligation so you can’t stop. You can’t stop  somebody else exercising that option. And if you’re on the other side of it, you’re going to get assigned.

And if you’re looking at your risk management tools, go into your portfolio and say that you short these options and their candidate or you’re at risk of getting assigned on these options.

And if you don’t want to carry the risk of potential assignment, at that point you may want to just close out or trade around it in a way that you’re not going to carry that that risk.

So you really want to look at it from both sides like you mentioned. Should I, if this is an early exercise, should I exercise it? And if I’m short, is there potential to get assigned on it? Should I close out of it or trade out of it so to avoid that risk?

Jeff

But it sounds like the person who is short the option would generally benefit if it’s not exercised early when it was supposed to, by the standard risk management tools.

I guess they could out maneuver themselves hedge themselves off. And then if they don’t get assigned. And all of a sudden they’ve kind of spent some extra premium kind of hedging around thinking they’d be assigned. But that’s the accurate statement; the person who’s short the position benefits if it doesn’t get exercised when all things say it should be exercised.

Dmitry

Exactly. So when an option is an early exercise candidate and there’s an economic benefit to exercising that option, if the owner of that option forgets or chooses not to exercise, the benefit goes to the other side, which is the short side of the option.

So imagine you have a “deep in the money” call and you’re short that deep in the money call and you’re long stock against it.

You’re carrying this buy, right? Well, if you’re not assigned on your call, then your long stock will receive a dividend, right? So, you’ll actually receive the dividend. If you’re not assigned on it, and you’re long stock and your stock doesn’t get called away, that stock will receive that dividend.

So yes, the benefit will go to the person on the short side of that option. If somebody forgets or chooses not to exercise an option, that is a good candidate for an early exercise.

Jeff

Well, this was a great discussion. First of all, I really enjoyed the webinar we just did prior to this podcast. Any last thoughts you’d like to leave our listeners with on the early exercise and assignment of options?

Dmitry

Yeah, I think it’s important to know when options are an early exercise. If you’re going to trade options, you should know when is the call for a candidate for an early exercise. When is it put? Also, how to do the cost benefit analysis and make it part of your risk management tools. You want to avoid having a situation where you forget accidentally or you’re not paying attention and you get a sign when you don’t want to.

You need to always have that as part of your risk management tools if a put or call is a candidate for an early exercise. So, I’m just going to leave it at that.

Jeff

No, that that’s perfect. And again, for our listeners for more detailed information, there’s a link to the webinar we just finished up on this exact subject that I would highly encourage everyone to go see.

It’s going to be in the study notes and to see more educational material from Market Chameleon, go to IBKR.com, click on ‘Education’ in the top right, then IBKR campus, then click on our Contributors and look for Market Chameleon.

Thank you for listening.

Until next time, I’m Jeff Praissman with Interactive Brokers.

Dmitry and Will

Thanks Jeff.

Contact Information:

https://marketchameleon.com/

[email protected]

2 thoughts on “To Early Exercise or Not, That is the Question”

  1. Hello – I tuned it to pick up some tips and generally learn how to better my trading knowledge and skills, and appreciate the information shared. Note however, that you have the wrong link to ‘listen in’ – which was my first choice. I read through the article instead, and gleaned some wisdom. :o)

    1. Hello David, thank you for pointing this out to us. This change is now reflected in the article. We appreciate your feedback!

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