When and Why Will My ITM Strike Be Exercised?

09/10/2013 8:00 am EST

Focus: OPTIONS

Alan Ellman

President, The Blue Collar Investor Corp.

To determine the likelihood of early exercise, we need to look at the option premium of an in-the-money strike, writes Alan Ellman of TheBlueCollarInvestor.com.

Covered call writers receive option premiums for undertaking the obligation to sell our shares to the option holder if that holder decides to exercise that right. Understanding when and why exercise will take place is critical to the implementation of appropriate exit strategies and therefore maximizing our option and stock profits.

Let’s first look at our covered call trade from the perspective of the option buyer. As the holder of the call option, the buyer’s goal is to make the most money possible. This can be accomplished by exercising the option and buying the stock below market (when the strike price is in-the-money) or by selling the option prior to expiration. If the strike price is in-the-money will the options be exercised early (prior to 4:00 pm EST on expiration Friday), will they be exercised after expiration Friday or will they never be exercised? To get an understanding of how this works we must first look at the premium of the call option and the equation that defines what the premium consists of:

Option premium = Intrinsic Value + Time Value

The intrinsic value is the amount that the option strike price is in-the-money and time value is the amount above the intrinsic value. If the option buyer exercises the option, the intrinsic value is captured but the time value is forfeited. This means that it is highly unlikely that the option will be exercised early. A rare exception to this rule is when a dividend is about to be distributed prior to expiration and the dividend amount is greater than the time value remaining on the premium. Let’s look at a real-life example to make all this come alive:

On August 24, I published an article on this site showing a trade I made using KORS as my underlying. KORS was purchased for $72.36 and slightly out-of-the-money $72.50 calls were sold. As of September 1, the share price rose to $74.09, leaving the $72.50 calls now in-the-money. The question now is will early exercise occur and my shares be sold? To get an answer, we look to a current options chain:

chart
Click to Enlarge

Amount option holder will receive if early exercise is invoked and shares are sold:
Amount generated = $74.09 – $72.50 = $1.59 or $159 per contract

Amount option holder will receive if option is sold rather than exercised:
Amount generated = $2.95 or $295 per contract

The breakdown of the option premium is as follows:
$2.95 = $1.59 (intrinsic value) + $1.36 (time value)

It is apparent that if the holder chooses the path of early exercise, time value will be lost and that makes no financial sense. Now if there is a dividend distribution prior to expiration Friday in an amount greater than $1.36, early exercise would be much more likely but not guaranteed (many retail investors do not know about dividends and ex-dates).

Are we assured that early exercise will not occur if there is no dividend to consider?

No. Some investors want to own the stock and will exercise (rarely) even if selling the option will make more sense. We cannot account for other investors making poor financial decisions. These investors should sell the option and then buy the shares at market thereby capturing the time value that early exercise would deprive them of. In these unusual instances, The Options Clearing Corporation (OCC) randomly assigns exercise notices to brokerage firms, which then assigns these notices to their customers (could be you or me!). Our covered call writing decisions should not be based on rare and unusual circumstances but rather on the most likely scenario, which is that our in-the-money strikes will not be exercised (barring a dividend issue) prior to 4:00 pm on expiration Friday. Therefore, if we wanted to hold onto our shares, we would need to buy back or roll the option prior to expiration.

Conclusion
To determine the likelihood of early exercise, we need to look at the option premium of an in-the-money strike. Early exercise will result in loss of time value for the option holder and therefore makes no financial sense. Early assignment is possible when there is a dividend distribution or when the holder incorrectly decides to exercise early and the assignment randomly falls to our account.

By Alan Ellman of TheBlueCollarInvestor.com

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