Exercising Call Options to Capture Dividends: A Reasonable Action or Investor Error? – December 27, 2022
Dividend capture is the main reason for early exercise of our covered call writing trades. More specifically, ex-dividend dates are the times most susceptible to early exercise and having our shares sold at the strike price. This article will analyze the profitability or lack thereof of taking such action.
On July 3, 2022, Graham shared with me a covered call trade he executed with New Residential Investment Corp. (NYSE: NRZ) where early exercise did occur on the ex-date. Was this a positive for the option holder? How about for Graham?
Graham’s NRZ trade
- 6/21/2022: Buy 2500 x NRZ at $9.34
- 6/21/2022: STO 25 x NRZ 7/15/2022 $9.00 calls at $0.60
- 6/30/2022: NRZ ex-dividend date
- 6/30/2022: 25 x $9.00 calls exercised early, and shares sold at the strike price
NRZ: Initial & final returns using the BCI Trade Management Calculator
The spreadsheet shows the following calculations from 6/21/2022 to 6/30/2022 (red arrows):
- The final net option dollar credit is $1500.00 (6.42%)
- The final net stock dollar loss is $850.00 (3.64%)
- The final net combined credit is $650.00 (2.78%)
Option holder’s dividend capture choices prior to the ex-date (on 6/29/2022)
With the stock trading at $9.45 and the $9.00 call option bid price at $0.60 on June 29th, let’s analyze exercise versus selling the option and buying the shares. These are the option buyers’ choices if the goal is to capture the dividend.
Outcomes of early exercise
Option holder: A net credit of $0.70 per-share was generated at the time of exercise, missing out on a net credit of $0.85 if the option was sold and shares purchased prior to the ex-date. The difference is the time-value component of the call premium which was lost due to exercise of the option.
Covered call writer: The trade resulted in a maximum gain with no dividend capture ($0.25 per-share). However, the cash from the sale of the stock was now available to enter a new covered call trade from 6/30/2022 through 7/15/2022. It is reasonable to assume that more than $0.25 per-share can be generated with 15 days remaining until contract expiration. We must also factor in that on the ex-date, the share price will decline by the projected dividend amount.
Discussion
The analysis shows that early exercise was the result of investor error. The call buyer could have generated higher returns and the call seller benefitted from this mistake (assuming the covered call writer was okay selling the shares).
Author: Alan Ellman