Option Calisthenics Early Exercise in Calls and Puts

1. Steve Papale March 11, 2013 Option CalisthenicsEarly Exercise in Calls and Puts

2. Army Training Sir!

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4. Exercise v Assignment American v European Options Factors Determining Early Exercise Synthetics Example Summary Topics

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6. Different side of the same coin Holder of option “Exercises “ his right Seller of option is “Assigned” his obligation Exercise or Assignment

7. 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 American v European

8. Interest Rates Options are a leveraging instrument Rates increase – Calls go up – levering effect Puts go down – short stock effect Determining Factors

9. 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 Dividends

10. 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) Synthetics

11. 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! Early Exercise of Puts

12. 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. Thanks Mr. Brown

13. If cost of call is less than the remaining cost of carry on the long stock – +C and -S

14. Exercise!

15. 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 The Unwind

16. + 10 IBM Jan 145 Puts + 1000 IBM (implied) -10 Jan 145 Calls (implied) 30 days until expiration = $.40 cost of carry for stock Example IBM

17. 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 Near Expiration

18. 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 Early Exercise for Calls

19. 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 Dividend is the Key

20. 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 More Stuff

21. 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. MSFT = $27

22. 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 Summary

23. Steve Papale DiscoverOptions stevep@discoveroptions.com 800-733-6610 PLE Capital Management, LLC www.plecapitalmanagement.com steve@plecapitalmanagement.com 847-863-8272 Thank You