OPTION CALISTHENICSEARLY EXERCISE IN CALLS AND PUTS

Steve PapaleMarch 11, 2013

ARMY TRAINING SIR!

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TOPICS Exercise v Assignment American v European Options Factors Determining Early Exercise Synthetics Example Summary

WE ARE A FULL SERVICE EDUCATORST PATRICK FACTS

St. Patrick was born approximately 390 AD near Kilpatrick, Scotland

The first parade was held in Boston in 1737, not Ireland

Chicago dyes its river green each year There are more Americans of Irish origin

than there are Irish in Ireland An estimated 13 million pints of Guinness

will be consumed on the holiday

EXERCISE OR ASSIGNMENT Different side of the same coin

Holder of option “Exercises “ his right

Seller of option is “Assigned” his obligation

AMERICAN V EUROPEAN American Options can be exercised

before the expiration date. OEX, Equity Options

European Options can only be exercised on expiration date.

SPX, XEO, RUT, NDX

DETERMINING FACTORS Interest Rates Options are a leveraging instrument Rates increase – Calls go up – levering effect Puts go down – short stock effect

DIVIDENDS Lowers stock by amount of dividend

on ex-dividend day

$.25 dividend – stock will devalue by $.25 on ex – dividend day.

Price may or may not move by that amount

SYNTHETICS Options can be combined with

stock/futures to create other options.

C = P + S P = C – S -C = -P – S -P = -C + S (covered call)

EARLY EXERCISE OF PUTS Think in terms of the synthetic If we are long a put then P = C – S or P – C = S

Note: Even if you don’t have synthetics on think in terms of equations to help predict early exercise or assignments!

THANKS MR. BROWN To predict the exercise of the put look at

the call and interest we pay to carry the stock (cost of carry)

P – C = S If we exercise we must unwind entire

equation Think high school algebra If we sell put (exercise) than we buy the

call and sell the stock.

+C AND -S

If cost of call is less than the remaining cost of carry on the long stock –

EXERCISE!

THE UNWIND Our original position: +P -C +S

We would then +C -S -P (exercise)

Remember this is decision process for economically efficient exercise – you may not have all this on

EXAMPLE IBM + 10 IBM Jan 145 Puts + 1000 IBM (implied) -10 Jan 145 Calls (implied)

30 days until expiration = $.40 cost of carry for stock

NEAR EXPIRATION Assume cost of carry is now $.20

Remember we have +P +S which equals +C

If the call is trading at $.10 which is less than$.20 cost of carry we exercise put(-P) and –S and buy outright call

Result: Save $.10

EARLY EXERCISE FOR CALLS

Dictated by dividends Familiar algebra +C –P = –S Being long the call implies being short the

stock Short stock means we collect interest on

credit in the account (opposite of long stock) Note – not in most retail accounts

DIVIDEND IS THE KEY Economically, if dividend is greater

than short stock rebate than we exercise.

Most retail will exercise day before ex-dividend to capture dividend

In the money calls only

MORE STUFF Use the put as a proxy – if put is less

than dividend - exercise

Can also sell call – especially when stock too expensive to buy

Don’t do nothing – unless high interest rates

MSFT = $27 Dividend = $.23

Ex date is 2/19

Ceteris Paribas – Stock will drop by $.23 on 2/19.

All strikes with puts trading below $.23 exercise.

SUMMARY Early exercise on puts pretty easy to

predict Only on American options Interest rates and Dividends are factors Think like a market maker when trying to

predict – it’s all about the synthetic Delta will tell us – generally 90 or up We should never have to worry about being

assigned in our program

THANK YOUSteve PapaleDiscoverOptionsstevep@discoveroptions.com 800-733-6610PLE Capital Management, LLCwww.plecapitalmanagement.comsteve@plecapitalmanagement.com847-863-8272