Saturday, April 13, 2013

Options 2.0 – Part 16. Dividend & early exercise call options

Dividend & early exercise call options
The dividend season has begun. This is particularly important for investors, because the receipt of dividends can generate income. And if you're an options investor? Then you’d better watch out.

Dividend – important for the value of options
Dividend is one of the 6 parameters that directly affect the valuation of options. This is actually when it all starts to happen: it’s extremely difficult for private investors to unravel which shares go ex-dividend and when, and how big the dividend amount will be. On the ex-dividend day the share price will open, minus the dividend amount.

Early Exercise: when exactly?
Amsterdam share options are American style. American style options may be exercised early. But what happens to your call option position if you exercise them early? And when precisely should you do that?
There is in principle only one optimal moment to exercise call options early: on the last trading day prior to the ex-dividend date. And that only applies to in-the-money call options, where the remaining call option time value is smaller than the dividend amount to be received. In this case, a call option with a short maturity is 'early exercise' and you are financially better off if you receive the dividend or sell the call option before the ex-dividend date. Also, by going ex-dividend, you’ll prevent a decrease in the value of the call option. Such a decrease in value results in unnecessary loss. For call options with a long maturity it’s slightly more complicated, as you must also take the interest component into account.

A Sample Calculation
An Ahold share is listed at 12.055 upon closing (11th April).
Ahold is intending to go ex-dividend on 19th April, with a dividend amount of 0.44.
The call 17-May-13 11.00 has a (bid price) of 1.02 - (ask price) 1.07.
This call option now lists under parity; the intrinsic value of 1.05 (= share price of 12.055 - call strike price of 11.00) is higher than the price that you receive for the call option. And there is a negative remaining time value (-0.035).

So, where is the profit if you have call options?
If you exercise this Ahold call option early, so at the optimum moment of one trading day before ex-dividend, then you’ll get the dividend and receive the dividend amount of 0.44. You’ll have effectively 'swapped' your call for shares. And the dividend amount will be considerably higher than the remaining time value of the call option. Of course, as the owner of a call option, you’ll naturally receive no dividend. You should definitely calculate it because you can really earn extra money by exercising early. In this example (on the last trading day before ex-dividend), you buy shares for the strike price of 11.00 and voila, you list them the following day for 0.44 dividend. You would never have achieved this, had you maintained your long call option position. If you don’t want any Ahold shares and dividend, then it’s wise to sell the call option before the ex-dividend date because the value of the call option increases considerably ex-dividend. And that results in unnecessary loss.

Are you long or short?
If you own call options (you are "long") and you exercise them early, then you lose the remaining time value. You can then buy the shares at the level of the strike price, because you (by definition with call options) have the right to buy. The shares that you receive at the strike price can subsequently be sold for the current market price of the share. The dividend receivable must therefore outweigh the remaining time value that’s left to run. Otherwise you’re better off just selling the call option.

If your call options are 'short' and the counterparty exercises the call option early, then it is you who is obliged to deliver the shares at the level of the strike price. With a short call, you have a delivery obligation. Note: if you don’t have the shares in your possession, then you must first purchase them for the current share price.

European Style Index Options
Index Options in Amsterdam are European style. And that means that you cannot exercise them early. Which results in the following situation: an AEX-index call option with a shorter maturity has higher option premiums than an AEX index call option with the same strike price and a longer maturity. Take a look at the option price of the in-the-money calls AEX 340.00 for April and May 2013 expiration. And notice the negative difference. This is due to the expected dividend between April and May expiration of 5.68 index points.

Dividend Agenda
Keep a close eye on the dividend calendar. Below, we’ve supplied both the AEX and AMX expected dividends for the following two weeks:
• TNT Express EUR 0.03 dividend, ex-dividend date 12-Apr-13
• Wessanen EUR 0.05 dividend, ex-dividend date 18-Apr-13
• Ahold EUR 0.44 dividend, ex-dividend date 19-Apr-13
• Heijmans EUR 0.25 dividend, ex-dividend date 19-Apr-13

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Please note that this example is for illustration and education purposes only and does not incorporate transaction costs. This example is not a recommendation.

Herbert Robijn is founder and director of FINODEX ( FINODEX develops innovative online investment tools for private equity and options investors. These cutting-edge tools allow investors to make a comprehensive market analysis, complex calculations and appropriate selections, at just the touch of a button.

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