Covered Call Writing: Early Exercise Of Options

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 |  Includes: VIT
by: Alan Ellman

When we sell a covered call option, we are undertaking an obligation for which we are well paid. Should the option holder decide to exercise that option, we must sell our shares at the specified strike price at or prior to the expiration date. This is the nature of American style options as opposed to European style options.

American style options: an option contract that may be exercised at any time between the date of purchase (sale) and the expiration date. These are the options that we, as CC writers, deal with.

European style options: an option contract that can only be exercised on the expiration date.

For the most part, share assignment will not occur until after expiration Friday when the agreed upon strike price is below the current market value. For example, if we sold the $50 strike and the current value of the stock is $52, the option holder or brokerage will exercise that option and achieve a $2 per share profit.

Why aren’t most options exercised early?

Option value consists of intrinsic + time value. Early exercise will result in the holder surrendering this time value, so it rarely occurs. The option owner may sell the call to capture the time value but early exercise and purchase of our shares does not make sense if there is significant time value remaining ($0.25 or more). It’s true that the shares can be purchased and then sold at market to capture this value but why not just sell the call? This concept applies to I-T-M and at or near-the-money strikes as O-T-M strikes would never be exercised.

How is it determined which shares are assigned if early assignment?

This is a completely random process whereby the Options Clearing Corporation (OCC) decides to which brokerage the assignment will be given and the brokerage will then pass it on to one of its clients.

Why does early assignment occur?

As time value declines (below the aforementioned $0.25), the chances of early assignment increases. There are times when the calls trade below the intrinsic value and in these cases the chances of early assignment are much greater. This will occur when the strike is deep I-T-M. Let’s look at the options chain for Vance Info Technologies (NYSE:VIT), as an example:

Early Assignment Possible for $12.50 Call
Early Assignment Possible for $12.50 Call

Note that the intrinsic value of the $12.50 call is @ $3.25 (since the stock price is $15.75) and yet the bid or our sale price of the option is $3.10 (red circle). Not only is there no time value for this option but it is actually trading below the intrinsic value. The last sale was @ $3.25 which is actually the exact amount of intrinsic value. The $15 strike, on the other hand, has time value of $0.35 ($1.10 – $0.75). As your strike moves deeper I-T-M, the chance of early assignment increases.

Other factors that may lead to early assignment:

1- Dividends- When your equity is about to distribute a dividend, early assignment is possible for I-T-M strikes when that dividend value is greater than the time value remaining for that option. This will take place prior to the ex-dividend date or the date share ownership is required to be eligible to capture this dividend.

2- High Open Interest- When you see thousands of open contracts we know that the institutional players are involved. Their trading costs are near zero and their arbitrage opportunities are greater than ours when time value approaches zero.

3- Pinning the Strike- when puts and calls are near the money on expiration Friday, there is a tendency called pinning the strike for the stock to move to the strike price or slightly beyond. This may result in assignment (not early, but unexpected) after the bell. This can also take place if there is a report or late news coming out the day of expiration.

How to avoid assignment:

1- To generate more cash (mid-contract) - If there is little or no time value remaining in our option (sold) why not unwind our position? B-T-C the call and sell the stock thereby re-capturing the time value. Now take that bundle of cash and re-invest it in another CC position. You can also roll the call out or up and out if the calculations are favorable. Remember, CC writers are tough “bosses”. No vacations or days off for our cash. They are put to work at all times during normal market conditions.

2- To avoid tax consequences- If your cost basis is much lower than the current market value of your shares, assignment may result in an unfavorable tax consequence. In these cases, you will want to close or role your calls before assignment. If your shares are unexpectedly assigned, you can purchase new shares at market and inform your broker that these new shares are to be the ones associated with the assigned option. Please check with your tax advisor and brokerage on these matters.

Conclusion:

Early assignment of your shares is rare but possible. Understanding why and when it may occur will further add to the bottom line of your investment success.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.