fixing a strategy after early exercise

[dr_trick]

hi everyone,

i'm curios about this: is it possible to rescue an options strategy after an early exercise on short call?

for example let's say you traded a condor, which includes a short ITM call, the whole set expires in some time away but you get exercised early on the short call because the stock is going ex-div. after the exercise the account now has a short position on the stock and at the same time you are liable for the dividend on the stock.

so the question is: do you close the other legs of the strategty or replace the short call with a new one. closing the other legs of the strategy means possibly losing some extrinsic value from some other short positions - and paying a huge spread on the long positions.

i was thinking of buying some stock to cover a possible early exercise close to the ex-div day to remove the dividend liability so that the short call can be replaced; and the strategy is held to expiration to hit some point on the expected payoff. does this make any sense?

thanks in advance.

cheers

 

[Windlesham1]

I stopped trading equity options because of the variables. You never ever know when the CEO is going to be caught inflagranti delecto etc.
But to answer your question, you would presumably not want the stock but your outer calls of the condor will have bumped up somewhat in value. I would simply close out the other 3 (2long one short) legs,assuming you are talking about a vertical 4 legged condor and not an 'iron'. Usually the divi is priced into the option so there is no arbitrage, otherwise everyone would be doing it.

 

[Martinghoul]

Well, ask yourself these questions... Firstly, under what circumstances is it optimal for someone to exercise their calls early after a dividend? Secondly, what happens to the calls you're long after such an event? Thirdly, how do you know how much stock you need to buy to hedge the early exercise?

 

[dr_trick]

I stopped trading equity options because of the variables. You never ever know when the CEO is going to be caught inflagranti delecto etc.
But to answer your question, you would presumably not want the stock but your outer calls of the condor will have bumped up somewhat in value. I would simply close out the other 3 (2long one short) legs,assuming you are talking about a vertical 4 legged condor and not an 'iron'. Usually the divi is priced into the option so there is no arbitrage, otherwise everyone would be doing it.

thanks. i think the only issue i have with closing the other legs is that the spreads somehow conspire to leave one with a profit that is just under the total dividends pushing the trade into a loss; this is while the stock is trading at a profitable point on the payoff curve.

 

[dr_trick]

Well, ask yourself these questions... Firstly, under what circumstances is it optimal for someone to exercise their calls early after a dividend? Secondly, what happens to the calls you're long after such an event? Thirdly, how do you know how much stock you need to buy to hedge the early exercise?

hi... thanks for your reply.

in response to your questions, i'd say:

1. i was looking at the case that the exercise is done to receive the dividend - i suppose this is optimal to exercise the call for the dividend if the cost of a put at the same strike is lower than the dividend received.

2. the long calls will also go up.

3. to hedge the early exercise i was thinking of buying the stock on the day before the ex-div date (i've been assigned twice already and they always seemed to happen on the day before ex-div). just buying the same number of shares i'm exposed to on the short leg(s).

i think i've worked myself into a confused state... need to clear my thoughts and post again on this. :|

thanks

 

[Martinghoul]

Ha, sure, you just need to think carefully about the various possibilities and you'll get to the bottom of it, I'm sure...

I would say the key issues you need to be aware of is that, generally speaking, options price in dividends. Therefore, early exercise is likely in a case where the dividend is significantly different than expected and materially changes the cost of carry dynamics. How likely is this? So it's only the case of the exercise being optimal for the other guy, while being suboptimal for you that matters...

In terms of hedging the early exercise, the point I was trying to make is that you need to hedge the probability, rather than the certainty of early exercise. That means you need to buy the probability-weighted amount of stock, rather than the same amount of shares. So, given you've been assigned twice, how many times have there been no assignments?

 

[dr_trick]

So, given you've been assigned twice, how many times have there been no assignments?

none... i put in two trades and was assigned twice. the first trade was assigned to me about three days before the options were due to expire and the second trade was assigned to me a full 3 months before expiry.

now i find myself saying "fooled me twice, shame on me."

and i can see clearly that both exercises took place just before ex-div date and i can see my broker has debited the dividends for the short positions held on ex-div date from my cash balance.

 

[Martinghoul]

none... i put in two trades and was assigned twice. the first trade was assigned to me about three days before the options were due to expire and the second trade was assigned to me a full 3 months before expiry.

now i find myself saying "fooled me twice, shame on me."

and i can see clearly that both exercises took place just before ex-div date and i can see my broker has debited the dividends for the short positions held on ex-div date from my cash balance.

Ah, interesting... Have you looked into the exact details of the pricing going into the early exercise? While I can imagine it happening 3 days ahead of expiry, early exercise is certainly not a very common occurrence for options 3mo to expiry in my experience. Of course, we never had an environment where interest rates were quite this low, which may have something to do with it, but still... Was it a DITM call?

 

[dr_trick]

Was it a DITM call?

the call was ITM when I entered the trade, and was DITM by the time i was assigned.

 

[Martinghoul]

the call was ITM when I entered the trade, and was DITM by the time i was assigned.

Makes sense. This does require some reasonably careful thinking. Not the strategy part necessarily, but rather the whole idea of optimal early exercise more generally. Given where rates are (and where they're headed) things are only likely to get more interesting.