As you probably know by now, Apple (AAPL) goes ex-dividend on Thursday, February 7. This means that the stock price will exhibit a $2.65 adjustment to your account for the fact that the company is now worth $2.65 per share less than it used to be worth prior to showering its stockholders with $2.65 per share in cash. Now, option prices typically take the dividend into account so that traders can’t exploit the effects of the stock adjustment. Nevertheless, you still have to pay attention to what happens when stocks go ex-dividend. To illustrate, consider the following example…
Better to Be Lucky than Good
On Monday, AAPL closed near $442 per share. Suppose that you were fortunate (lucky) enough to use options to establish a long delta position in AAPL on Monday by way of buying a 440/455 call spread (expiring this Friday February 8th) for $5.00 as shown below (buying the 440 strike call and selling the 455 call). It’s not impossible. I have students in my classes that love to remind me that they are far better stock pickers than I could ever hope to be.
Being that you bought a 15-point spread for $5.00, this implies a trade in which you risked $5.00 in order to make $10.00. From a reward to risk standpoint, let’s suppose you’re happy with your trade. In hindsight, I would be happy to.
On Tuesday, AAPL rallies to close near $459 per share. Your 15-point spread is now completely in the money and needless to say, your trade is a winner. Your $5 investment is now worth about $12.50. That’s not bad for a trade that expires in a couple of days.
But remember that AAPL goes ex-dividend on Thursday to the tune of $2.65 per share. You probably already know that call options are adjusted lower in order to take into account the effect of the upcoming stock adjustment due to the dividend. So, there’s nothing to worry about, right? Wrong.
The non-overly-mathematical rule that pertains to call early exercise is as follows:
A call option should be exercised early if on the day prior to the ex-dividend date, the value of the dividend exceeds the value of the put option having the same strike and expiration.
The PUT? Yes, the put. Here’s why:
You have two forces fighting each other right now, each trying to adhere to the rules that pertain to option pricing. The problem is that the rules appear to contradict each other.
Rule #1 is that a call option should be adjusted downward by the anticipated effect that the dividend-based stock adjustment will have on the call. This downward adjustment be approximated as the dividend amount times the call delta. That said, given a dividend of $2.65 and an approximate call delta of 0.90, then you can assume that all else equal, the call option should be adjusted downward by a value of:
(2.65) * (0.90) = 2.385, or about $2.39.
Rule #2 states that an American-style option should never be sold below the amount that the option is in-the-money. Otherwise, we’d have an instant arbitrage that someone could exploit.
And here’s where the issue lies. This second rule implies that in order to make a downward adjustment to the value of an option, the adjustment cannot come from the real value of the option, but rather from the time value. The problem is that looking at the put option, you can see that there’s only about 70 or so cents of time value in the 440 strike, and we need about two dollars more than that.
So What Do You Do?
You compromise. You drop the value of the call by as much as you can, but not below intrinsic value (that said, the bid may be set just under intrinsic, so pay attention). Now, you have to be aware of what will take place on the ex-dividend date, since your call options was not adjusted enough prior to the ex-date.
So What Happens?
If the stock price and option chain remained the same through Wednesday’s close, being long the 440/455 call spread, the position would lose about $2.00 on the opening Thursday, all else equal.
Remember the rule for call early exercise. The $2.65 dividend is greater than the value of the 440 put. Therefore, the 440 calls should be exercised. However, the 455 puts are worth much more than $2.65. This implies that there was enough room to adjust the 455 calls prior to the dividend. Exercise of the 455 calls is therefore unlikely as a full adjustment has been allowed to take place.
On the ex-date, the stock will be adjusted $2.65 lower. This will move the 440 calls down the remaining $2.00 or so that they could not be adjusted prior to the ex-date. The 445 calls would not be adjusted, as there would be nothing more to adjust.
As a result, you could end up giving back around $2.00 on a spread currently worth about $12.50 to you. That’s a lot of money (about 16% in one day) to forfeit just because you were confused by the ex-dividend date process.
Of course, you could always exercise your calls, take delivery of the stock, buy the 440 puts to replicate your old position, and continue with the trade. But you need capital, more commissions, and probably a lot more attention to detail than you signed on for on a simple vertical spread where all you were trying to do was buy the bottom.
So What Else Can You Do?
You could simply sell out your spread prior to the ex-date. I know. It’s not as glamorous as the other alternatives, but some fights may not be worth be worth the punishment received, even if in the end, you are victorious. And expiration is Friday the 8th.
Finally, even if you don’t currently have an AAPL position, I would at least urge you to look at the open interest amount of each call option within the first two expirations (the 8th is a Weekly, the 15th is regular expiration) and with strike prices of 440 and lower. Most of those options should be exercised early according to current levels. However, many of them inevitably will remain unexercised. That being the case, the long option holder would have left a significant amount of money on the table. How much money? About $265 per option contract. Considering that the open interest for the options in question is in the thousands, any options that are not properly exercised are likely to mean a positive surprise for the holders of the respective short call option positions.