Stock options are American style and it is good to know when an option is likely to be exercised ahead of the expiration date
Let?s keep in mind that American style options, unlike European style options may be exercised at any moment in their lifetime. As said above, stock options are American style and it is good to know when an option is likely to be exercised ahead of the expiration date. This is of particular importance if you are short these options.
When thinking about calls they are unlikely to be exercised early unless a dividend is about to be paid. Remember, dividends are only paid to shareholders and not option owners no matter how deep in the money (ITM) that option may be.
The option specification may say that the call expires on the third Friday of the month, but if a dividend is going to be paid 7-10 days before that all the ITM calls are almost certainly going to be exercised the day before the dividend is about to be paid.
If you own the stock against a short call you will likely have your stock ?called away? before the dividend is paid.
And if you are short ITM calls against other long calls you are going to end up being short the stock and thereby lose the
dividend. Anyone who is short the stock over the dividend date must pay the dividend to the stock lender (more on what is short stock in a further chapter).
Therefore, any option trader must always know what the dividend is and when the dividend will be paid. Stock before the dividend is paid is said to be ?cum dividend? and stock after the dividend is paid is said to be ?ex dividend?.
As for puts, a deep ITM put is likely to be exercised early ex dividend if the stock is unlikely to rise to that strike price. Or, if the call at that strike is trading under what you have to pay to carry the stock, ie, the ?cost of carry?.
By way of illustration, let?s say XYZ is trading at 100 and I own the stock and I own the 150 put. The only way that position will make money, barring a dividend, is if the stock goes above 150 before expiration. And 50% moves in a stock are unlikely. So, the day the stock goes ex dividend I am likely to exercise the option early? and ?put my stock away?.
Just as if I am long the 50 call with the stock at 100 I am more than likely to early exercise that call so as to collect the dividend.
The takeaway here is that anyone long or short deep ITM options needs to closely monitor the position and any dividend payouts and dates.