Early exercise call option non dividend paying stock

Filed Under Beginner Options Trading. Options University More Contact Details. Open interest is generally used as a liquidity guide for trading purposes, especially if you are placing large dollar amounts into a particular option. It might appear as though this option is very liquid.

However, a better method is to take the , shares that it represents and multiply it by the market price of the option. The asking price on this July contract is five cents. If you are placing a large order, you may wish to check the open interest figure to gauge the liquidity.

In other words, if your order is substantially large relative to the amount of contracts at that strike, it is possible that your order could significantly move the market price. This is why many traders wish to check the actual number by looking at the open interest column as well as the total dollars represented in that option.

However, despite the apparent justification for checking open interest, you must realize that market makers and others stand by ready, willing, and able to provide liquidity. Just because an option may appear to be illiquid does not mean that it is. Chances are any order will get executed quickly and within reasonable limits of the current price.

The reason we make this clarification is because we find that many new traders get caught up in deciding if the open interest is sufficiently large for their order. Equity options options on stock are an American-style option, which means they can be exercised at any time prior to expiration.

To many traders, the exercise restriction that comes with European options seems like a negative feature. It seems sensible that there must be times when you would like to exercise a call option early to gain the stock.

Exercising an American call option early - Quantitative Finance Stack Exchange

Many traders believe this, so they do it every day. But it is one of the biggest mistakes in options trading.

Traders who exercise call options early end up with more risk while literally throwing money away, which is certainly not a winning strategy. When the drawbacks to early exercise are mentioned in many of our seminars, it is often met with heated debates but the participants quickly find that there are better choices once we give a few examples.

The point is that it is instinctual at times to want to exercise a call option early but it is, in most cases, the wrong move to make. To further confuse the early exercise issue, traders who exercise put options early may actually be better off at times. This section fully explains the differences to make sure you are not throwing money away due to illusory beliefs about options and early exercises.

With only one exception, we can say that it is never advantageous to exercise a call option early. The exception would be for those investors who wish to collect an upcoming dividend on a stock. Because option holders do not collect dividends, if they wish to collect it, they must exercise the option in order to take control of the stock. However, most dividends are relatively small and are usually not worth the risk of holding the stock — even if just overnight.

There is no limit as to the amount of money that either trader could make. But aside from that difference, both traders have unlimited upside potential.

At no point near expiration is one trader better off than the other when considering stock price increases. If the stock falls, the stock holder loses dollar-for-dollar all the way down to a stock price of zero. Call options have a very small, limited downside risk the price paid for the option when compared to that of the stock trader. At expiration, call options win dollar-for-dollar to the upside, but do not lose dollar-for-dollar to the downside.

When Should You Exercise an Option Early?

The second chapter showed that this asymmetrical property is one of the main reasons that traders buy calls in the first place. In other words, traders buy call options to avoid holding the risky stock. Traders are naturally drawn to this beneficial feature of calls.

Short-term traders and speculators survive by using stop orders or other types of risk-management techniques and the asymmetrical payoffs of call options provide an automatic risk management tool; the most you can lose is the amount you paid for the option.

Traders are completely disregarding this benefit when they exercise a call early.

Once you submit exercise instructions, you are swapping the call option for the stock and are now accepting the full downside risk of the stock.

That alone should be enough to convince you to not exercise a call early. The second part has to do with the time value remaining in the option.

However, prior to expiration, the call option must be worth at least S — E plus some time value Pricing Principle 4. When you exercise an option, you are only left holding the value between the stock and exercise price, or S — E. So if you just sell the call rather than exercise it you would be better off. By exercising a call option early, not only do you accept full downside risk in the stock but you also throw away the time value of that call option.

To put it in a more distressing way, you throw money away in exchange for accepting more risk! It does not matter how short of a time period you intend to hold the stock, either.