I understand why a call option holder may exercise early to capture a dividend on a stock. If they do not exercise, the price of their call will typically drop when the stock goes ex-dividend and the stock price drops by the amount of the dividend. I'm wondering exactly how they capture the dividend. Do they instruct their broker to exercise the call at the close of the market one day prior to the ex-dividend date, and then sell the stock at the open on the next trading day? That captures the dividend, but doesn't it also put the investor at risk not knowing how the market will open the following day? I realize there is a second scenario where the investor may want to be long the stock and will hold it after exercising, but I suspect that is a relatively modest percentage of investors.
The exercise is done because the calls are worth more exercised than not - due to the contractual nature of Amer. style options. Because Amer. style cannot have a FV below parity - the div. is not completely priced in. So it is a matter of "capturing" the value of the call - not the div. It can be closed by selling the call -or- short the stock, exercise call. Whatever the investor chooses to do with the position, ITM Amer. style calls with a FV below parity (if they were Euro style) should disposed of by the evening before ex-div.
Just one other wrinkle careful if you are not american(as in US citizen) dividends have a 15% withholding tax, so if you go, the sell stock exercise the call, you will be out 15% of the dividend amount.
I never understood that whole buy a call so you can exercise to capture premium. I though free lunches did not exist. cause if it was so great ever tom dick and harry would do this.
A known dividend will already be priced into the options, so the price of a call won't drop by the amount of the dividend on the ex-date -- it will already be discounted. There is no risk-free way to capture a dividend.
This is very simple. When the dividend is worth more than the value of the OTM put AND your costs to exercise, then you exercise your call early. Since the ITM call will be close to 100 delta option anyways, exercising the call early will not result in any immediate risks that weren't already in the position--though you may need to buy back the puts to replace the units in your portfolio for capital requirements. (Editor's note: I've only done this in market maker and pro accounts. I am not aware of the additional risks or costs to a public customer account.)
Thanks all for your replies. I'm actually a covered call writer and just wanted to understand the risk of early exercise. Sometimes I'll sell calls on a company like AT&T with a reasonably large dividend. The site referenced below is where I got my initial information. http://www.tradingmarkets.com/.site/options/how_to/articles/-76184.cfm Note the three cases in the example which explains the situation very well. According to what I have read, only a percentage of call holders will exercise early even when it might make sense. I've also read that big traders sometimes take advantage of that and sell a lot of calls before the ex-dividend date. They apparently can make a profit based on the call buyers who do not exercise early. I'm sure things need to line up properly to do this successfully.