Exercising an equity call option prior to expiration ordinarily provides no economic benefit as:
Nonetheless, for account holders who have the capacity to meet an increased capital or borrowing requirement and potentially greater downside market risk, it can be economically beneficial to request early exercise of an American Style call option in order to capture an upcoming dividend.
As background, the owner of a call option is not entitled to receive a dividend on the underlying stock as this dividend only accrues to the holders of stock as of its dividend Record Date. All other things being equal, the price of the stock should decline by an amount equal to the dividend on the Ex-Dividend date. While option pricing theory suggests that the call price will reflect the discounted value of expected dividends paid throughout its duration, it may decline as well on the Ex-Dividend date. The conditions which make this scenario most likely and the early exercise decision favorable are as follows:
1. The option is deep-in-the-money and has a delta of 100;
2. The option has little or no time value;
3. The dividend is relatively high and its Ex-Date precedes the option expiration date.
To illustrate the impact of these conditions upon the early exercise decision, consider an account maintaining a long cash balance of $9,000 and a long call position in hypothetical stock “ABC” having a strike price of $90.00 and time to expiration of 10 days. ABC, currently trading at $100.00, has declared a dividend of $2.00 per share with tomorrow being the Ex-Dividend date. Also assume that the option price and stock price behave similarly and decline by the dividend amount on the Ex-Date.
Here, we will review the exercise decision with the intent of maintaining the 100 share delta position and maximizing total equity using two option price assumptions, one in which the option is selling at parity and another above parity.
SCENARIO 1: Option Price At Parity - $10.00
In the case of an option trading at parity, early exercise will serve to maintain the position delta and avoid the loss of value in long option when the stock trades Ex-Dividend. preserve equity. Here the cash proceeds are applied in their entirety to buy the stock at the strike, the option premium is forfeited and the stock, net of dividend, and the dividend receivable are credited to the account. This can also be accomplished with the same end result by selling the option prior to the Ex-Dividend date and purchasing the stock:
Sell Option &
SCENARIO 2: Option Price Above Parity - $11.00
In the case of an option trading above parity, early exercise to capture the discount, while preferable to inaction, may not be economically beneficial. In this scenario, early exercise would result in a loss of $100 in option time value and inaction a loss equal to the $200 dividend. Here, the preferable action would be to sell the option to capture the time value and buy the stock, thereby realizing the dividend.
Sell Option &
NOTE: Account holders holding a long call position as part of a spread should pay particular attention to the risks of not exercising the long leg given the likelihood of being assigned on the short leg. Note that the assignment of a short call results in a short stock position and holders of short stock positions as of a dividend Record Date are obligated to pay the dividend to the lender of the shares. In addition, the clearinghouse processing cycle for exercise notices does not accommodate submission of exercise notices in response to assignment.
As example, consider a credit call (bear) spread on the SPDR S&P 500 ETF Trust (SPY) consisting of 100 short contracts in the March '13 $146 strike and 100 long contracts in the March '13 $147 strike. On 3/14/13, with the SPY Trust declared a dividend of $0.69372 per share, payable 4/30/13 to shareholders of record as of 3/19/13. Given the 3 business day settlement time frame for U.S. stocks, one would have had to buy the stock or exercise the call no later than 3/14/13 in order receive the dividend, as the next day the stock began trading Ex-Dividend.
On 3/14/13, with one trading day left prior to expiration, the two option contracts traded at parity, suggesting maximum risk of $100 per contract or $10,000 on the 100 contract position. However, the failure to exercise the long contract in order to capture the dividend and protect against the likely assignment on the short contracts by others seeking the dividend created an additional risk of $67.372 per contract or $6,737.20 on the position representing the dividend obligation were all short calls assigned. As reflected on the table below, had the short option leg not been assigned, the maximum risk when the final contract settlement prices were determined on 3/15/13 would have remained at $100 per contract.
|Date||SPY Close||March '13 $146 Call||March '13 $147 Call|
|March 14, 2013||$156.73||$10.73||$9.83|
|March 15, 2013||$155.83||$9.73||$8.83|
For information regarding how to submit an early exercise notice please see the IB website.
The above article is provided for information purposes only as is not intended as a recommendation, trading advice nor does it constitute a conclusion that early exercise will be successful or appropriate for all customers or trades. Account holders should consult with a tax specialist to determine what, if any, tax consequences may result from early exercise and should pay particular attention to the potential risks of substituting a long option position with a long stock position.
Equity option exchanges define position limits for designated equity options classes. These limits define position quantity limitations in terms of the equivalent number of underlying shares (described below) which cannot be exceeded at any time on either the bullish or bearish side of the market. Account positions in excess of defined position limits may be subject to trade restriction or liquidation at any time without prior notification.
Position limits are defined on regulatory websites and may change periodically. Some contracts also have near-term limit requirements (near-term position limits are applied to the side of the market for those contracts that are in the closest expiring month issued). Traders are responsible for monitoring their positions as well as the defined limit quantities to ensure compliance. The following information defines how position limits are calculated;
The following examples, using the 25,000 option contract limit, illustrate the operation of position limits:
IB will send notifications to customers regarding the option position limits at the following times:
Position limits are set on the long and short side of the market separately (and not netted out).
Traders can use an underlying stock position as a "hedge" if they are over the limit on the long or short side (index options are reviewed on a case by case basis for purposes of determining which securities constitute a hedge).
Position information is aggregated across related accounts and accounts under common control.
IB considers related accounts to be any account in which an individual may be viewed as having influence over trading decisions. This includes, but is not limited to, aggregating an advisor sub-account with the advisor's account (and accounts under common control), joint accounts with individual accounts for the joint parties and organization accounts (where an individual is listed as an officer or trader) with other accounts for that individual.
Regulations permit clients to exceed a position limit if the positions under common control are hedged positions as specified by the relevant exchange. In general the hedges permitted by the US regulators that are recognized in the IB system include outright stock position hedges, conversions, reverse conversions and box spreads. Currently collar and reverse collar strategies are not supported hedges in the IB system. For more detail about the permissible hedge exemptions refer to the rules of the self regulatory organization for the relevant product.
OCC posts position limits defined by the option exchanges. They can be found here.
Leveraged Exchange Traded Funds (ETFs) are a subset of general ETFs and are intended to generate performance in multiples of that of the underlying index or benchmark (e.g. 200%, 300% or greater). In addition certain of these ETFs seek to a generate performance which is not only a multiple of but also the inverse of the underlying index or benchmark (e.g., a short ETF). To accomplish this, these leveraged funds typically include among their holdings derivative instruments such as options, futures or swaps which are intended to provide the desired leverage and/or inverse performance.
Exchange margin rules seek to recognize the additional leverage and risk associated with these instruments by establishing a margin rate which is commensurate with that level of leverage (but not to exceed 100% of the ETF value). Thus, for example, whereas the base strategy-based maintenance margin requirement for a non-leveraged long ETF is set at 25% and a short non-leveraged ETF at 30%, examples of the maintenance margin change for leveraged ETFs are as follows:
1. Long an ETF having a 200% leverage factor: 50% (= 2 x 25%)
2. Short an ETF having a 300% leverage factor: 90% (= 3 x 30%)
A similar scaling in margin is also in effect for options. For example, the Reg. T maintenance margin requirement for a non-leveraged, short broad based ETF index option is 100% of the option premium plus 15% of the ETF market value, less any out-of-the-money amount (to a minimum of 10% of ETF market value in the case of calls and 10% of the option strike price in the case of puts). In the case where the option underlying is a leveraged ETF, however, the 15% rate is increased by the leverage factor of the ETF.
In the case of portfolio margin accounts, the effect is similar, with the scan ranges by which the leveraged ETF positions are stress tested increasing by the ETF leverage factor. See NASD Rule 2520 and NYSE Rule 431 for further details.
How to create option spread strategies using OptionTrader
The Options Clearing Corporation (OCC), the central clearinghouse for all US exchange traded securities option, operates a call center to serve the educational needs of individual investors and retail securities brokers. The resource will address the following questions and issues related to OCC cleared options products:
- Options Industry Council information regarding seminars, video and educational materials;
- Basic options-related questions such as definition of terms and product information;
- Responses to strategic and operational questions including specific trade positions and strategies.
The call center can be reached by dialing 1-800-OPTIONS. The hours of operation are Monday through Thursday from 8 a.m. to 5 p.m. (CST) and Friday from 8 a.m. to 4 p.m. (CST). Hours for the monthly expiration Friday will be extended to 5 p.m. (CST).
In order for the software utilized by IB to recognize a position as a Butterfly, it must match the definition of a Butterfly exactly. These are the 3 different types of Butterfly spreads recognized by IB, and the margin calculation on each:
Two short options of the same series (class, multiplier, strike price, expiration) offset by one long option of the same type (put or call) with a higher strike price, and one long option of the same type with a lower strike price. All component options must have the same expiration, same underlying, and intervals between exercise prices must be equal.
There is no margin requirement on this position. The long option cost is subtracted from cash and the short option proceeds are applied to cash.
Short Butterfly Put:
Two long put options of the same series offset by one short put option with a higher strike price and one short put option with a lower strike price. All component options must have the same expiration, same underlying, and intervals between exercise prices must be equal.
The margin requirement for this position is (Aggregate put option highest exercise price - aggregate put option second highest exercise price). Long put cost is subtracted from cash and short put proceeds are applied to cash.
Short Butterfly Call:
Two long call options of the same series offset by one short call option with a higher strike price and one short call option with a lower strike price. All component options must have the same expiration, same underlying, and intervals between exercise prices must be equal.
The margin requirement for this position is (Aggregate call option second lowest exercise price - aggregate call option lowest exercise price). Long option cost is subtracted from cash and short option proceeds are applied to cash.
*Please note that Interactive Brokers utilizes option margin optimization software to try to create the minimum margin requirement. However, due to the system requirements required to determine the optimal solution, we cannot always guarantee the optimal combination in all cases. Other option positions in the account could cause the software to create a strategy you didn't originally intend, and therefore would be subject to a different margin equation.
If an iron condor strategy exists in the account, then the margin requirement on that strategy will be the margin on one of the spreads in that iron condor. If the margin requirements on each individual spread is different, then IB will use the requirement that is greater.
To determine what the actual margin will be, calculate the margin requirement for each individual side of the condor:
For the call spread side, the margin requirement = (Maximum (aggregate long call strike - aggregate short call strike, 0)). The long call cost is subtracted from cash and short call proceeds are applied to cash.
For the put spread side, the margin requirement = (Maximum (aggregate short put strike - aggregate long put strike, 0)). The long option cost is subtracted from cash and short option proceeds are applied to cash.
Whichever of these formulas results in the higher requirement, that is the requirement that will be used.
*Please note that Interactive Brokers utilizes option margin optimization software to try to create the minimum margin requirement. However, due to the system requirements required to determine the optimal solution, we cannot always guarantee the optimal combination in all cases. It is possible that given the option positions in the account, the iron condor you are trying to create will not be recognized as such.
There are many different formulas used to calculate the margin requirement on options. Which formula is used will depend on the option type or strategy determined by the system. There are a significant number of detailed formulas that are applied to various strategies. To find this information go to the IB home page at www.interactivebrokers.com. Go to the Trading menu and click on Margin. From the Margin Requirements page, click on the Options tab. There is a table on this page which will list all possible strategies, and the various formulas used to calculate margin on each.
The information above applies to equity options and index options. Options on futures employ an entirely different method known as SPAN margining. For information on SPAN margining, conduct a search on this page for “SPAN” or “Futures options margin”.
There are two scenarios which could occur if a long option is taken to expiration. If the option is out-of-the-money at expiration and you do not choose to exercise it, the option will expire worthless, and your losses will consist of the premium that was paid to acquire the option. If the option is in-the-money at expiration by 0.01 or more, it will be automatically exercised on your behalf (unless you previously chose to lapse the option) by the Options Clearing Corporation (OCC). The OCC processes monthly expiration options on the third Saturday of the month, or the day after Friday expiration. The resulting long or short position will be put into the account, effective on the Friday trade date. If the account has sufficient margin to satisfy the requirement on the resulting position, it will then be up to the account holder to decide what they want to do with the position. If the resulting position causes a margin deficit, the account will be subject to liquidation at a time which is defined by the holdings within the account. Please be aware that any positions could be liquidated as a result of the account being in margin violation—the liquidation is not confined to only the shares that resulted from the option position. For example, if the account holds currency, futures, future options positions or and non-USD product, the account may begin to liquidate to meet the margin deficit as soon as a corresponding market opens.
Account holders should refer to the Characteristics and Risks of Standardized Options disclosure document which is provided by IB to every option eligible customer at the point of application and which clearly spells out the risks of assignment. This document is also available online at OCC's web site.
Account holders have the ability to exercise equity options they hold long in their account.
From Trader Workstation, go to the Trade menu and select Option Exercise.
The Option Exercise window will appear and the Current Long Option Positions box will populate with those options held long in the account. To exercise one of them, left-click on the option desired so that it is highlighted. In the bottom left corner of the Option Exercise window, click the Exercise button.
A window will appear allowing traders to adjust the number of contracts to be exercised. This window will also warn traders that are submitting an exercise request for positions that are out of the money. To exercise out of the money options, traders must check the box that says Allow exercising out of money options.
Once this is done the option will move into the Outstanding Exercises box until the clearinghouse processes the request. Once the option is moved to the Outstanding Excercises box, the action/request is irreversible.