Early Exercise of a Deep ITM Call Before a Dividend
An investor is long 50 call contracts on a stock trading at $96, struck at $60, expiring in 21 days. Each contract covers 100 shares. The stock will pay a $1.20 dividend in 9 days, and the ex-dividend date is in 10 days. The call is American-style and currently trades at $36.40, while intrinsic value is $36.00, so time value is $0.40 per share, or $2,000 across the position. The investor's broker charges $0.65 per contract to exercise and the same to sell. The investor is deciding whether to exercise now, sell the calls, or wait.
1. Analyze whether early exercise is rational here and quantify the trade-off.
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Early exercise is rational only when the dividend captured exceeds the time value forfeited plus transaction costs. Exercising now captures the $1.20 dividend on 5,000 shares, or $6,000, but forfeits the $0.40 per share time value, or $2,000, and incurs exercise cost of 50 x $0.65 = $32.50. Net benefit is roughly $6,000 - $2,000 - $32.50 = $3,967.50, before considering the cost of funding the $60 strike, which is $300,000 for 5,000 shares.
That funding cost matters. If the investor must borrow $300,000 for 10 days at, say, 5%, the interest is about $411. That still leaves a positive net benefit of roughly $3,556. So exercise is economically attractive on these numbers.
The alternative is to sell the calls at $36.40, realizing $182,000 and avoiding the $300,000 outlay and the exercise cost. Selling captures the time value rather than forfeiting it. The comparison is between exercising and holding the shares versus selling the calls and, if desired, buying shares in the market.
The decision hinges on whether the investor wants the stock position. If she does, exercising before ex-date is rational given the numbers. If she does not, selling the calls is cleaner.
2. What would change the answer, and what operational risks should the investor consider?
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The answer flips if the time value exceeds the dividend plus costs. Here time value is $0.40 against a $1.20 dividend, a comfortable margin. If the stock were less deep in the money, time value could be several dollars and exercise would destroy value. If the dividend were smaller, say $0.30, exercise would be value-destroying after costs.
Funding cost is the other swing factor. At a high borrowing rate, or if the investor cannot finance the $300,000, the benefit shrinks or disappears. The investor should compute the break-even funding rate: net dividend benefit of $6,000 minus $2,000 time value minus $32.50 costs leaves $3,967.50, which covers interest on $300,000 for 10 days up to an annualized rate of roughly 48%. So funding is unlikely to flip the decision, but it should still be checked.
Operationally, the investor must instruct the broker before the ex-dividend date, because exercise after the record date misses the dividend. She should confirm the broker's cut-off time and that exercise instructions are acknowledged. She should also confirm the dividend amount and ex-date, since a change in either alters the calculation. Finally, exercising creates a concentrated stock position and a tax event; both should be considered before instructing.