How Likely is Early Exercise on Our Barrick Gold Covered Call?

In the June 16th, 2014 Seasonal Forecaster newsletter I laid out the case for a bullish trade on Barrick Gold. The open on June 16th gave us an entry at 17.02.

In the June 27th newsletter I suggested selling July 18 calls against the stock to turn the trade into a covered call. At the open on the 27th, the call offered a credit of $0.53. This brought our cost basis on the trade down to 16.49.

I said “If ABX closes at or above 18 on July option expiration (7/18), I will let the stock be called away.“, and “…ABX closes above 18 on July 18th and the stock gets called away, then my return will be 9.1% for the 33 days in the trade, for a 100% annualized rate-of-return.”

This is July expiration week. We have 5 full trading days before the July options expire. This covered call position, with the July 18 call, is now significantly ‘in-the-money'. From the outset I said I would let the call be exercised if ABX was above 18 at the time of July expiration.

But what if you were in this situation and wanted to keep the stock? After all, why get rid of a good position? Gold, and gold stocks, have been strong recently. From the above chart, we can see a few good gaps, and the high volume bars on up-close days suggest this stock may have more to run. It looks like it is being accumulated by institutions. We may want to think about managing this covered call position so we end up holding the stock past Friday's option expiration.

We sold a call against the stock and received the full premium up-front. But if we do something to keep the stock, it means buying back the July 18 call early to avoid ‘early exercise'. What does this mean?

We sold a July 18 call to someone, meaning we gave someone the right to buy the stock at a price of 18. The stock is now at 19.29 That seems like a good deal. Someone who is holding a July 18 call could exercise it and buy the stock from us at 18, and immediately resell it for 19.29. But of course the original premium paid for the call would be a factor in whether it would be worth it for them to exercise the option and have to buy the stock from us at 18.

We could ‘roll-up-and-out' to an August 20 call, giving us more premium and allowing us to keep the stock, for a while at least. The July 18 call still has $0.03 in extrinsic value in it. We would have to give back $0.03 of our original $0.53 in premium received to buy back this call as part of a rolling trade. That's not bad, and I can probably stop the conversation right here and say it makes sense to roll up to the Aug-20 call (by simultaneously buying back the July 18 calls and selling an equal amount of new August 20 calls).

But in general, what if we are approaching expiration week, and we have a short call (or short put for that matter), and the call (or put) is in-the-money? How likely are we to get exercised?

The key in answering that question is understanding that every stock and/or position can be turned into another, equal type of trade. Market Makers, floor traders (what few are left), institutional traders, and nowadays, robot traders, do this regularly. In fact, our covered call trade (long stock and short a call) has exactly the same characteristics as a short put. Traders will convert positions into their synthetic equivalents in order to hedge, to obtain quantities not otherwise available, and so on. So someone could exercise a long call or long put before expiration, if it is profitable for them to do so.

When is it profitable? There is a balancing force in effect that prevents traders from regularly converting positions merely to capture pricing imbalances. It is called the Put-Call Parity. The formula is Call price – Put price = Stock price – Strike price + (Interest – Dividends). The formula can be reworked to solve for the current value of a call or put based on the other factors.

It would take a while to explain how the above formula works in all the cases when a short option transitions into ‘in-the-money', especially when dividends are involved. But the three general rules for determining whether you are likely to be early-exercised are:

– If you are short a put, the stock pays a dividend, and it is before the stock's ex-dividend date, you have a low chance of being exercised. But once you pass the ex-dividend date, the chances of early exercise greatly increase.

– If you are short a call and the underlying stock does not pay a dividend, it is very unlikely you will ever be assigned before expiration.

– If you are short a call and the underlying stock pays a dividend, and the dividend is greater than the equivalent Put value, you are likely to get assigned. In practice, you do not have to worry about this until the extrinsic value in the call falls below 0.25 to 0.05, depending on  interest rates. In my newsletters, I say watch for extrinsic value falling below 0.30 and then decide what you want to do, but with the currently low interest rates, you may be safe to low levels of extrinsic value. In most cases where dividends are small or won't go ex-dividend soon, you can go into the morning of expiration day before rolling your short call, in order to capture as much premium decay from the original sale.

In summary, with the current ABX covered call position and Barrick's low dividend not going ex-dividend again until mid-August, it is possible, but not likely, to be assigned early. My original trade goal was to allow exercise if it happened. But if exercise hasn't already occurred, it is worth considering a roll-up-and-out to August 20's. There is no reason to doubt further upside on ABX at this point.

Of course there's much more you need to know and many more stocks you can capitalize upon each and every day. To find out more, please click on the following link: www.markettamer.com/seasonal

By Gregg Harris, MarketTamer Chief Technical Strategist

Copyright (C) 2014 Stock & Options Training LLC

Unless indicated otherwise, at the time of this writing, the author has no positions in any of the above-mentioned securities.

Gregg Harris is the Chief Technical Strategist at MarketTamer.com with extensive experience in the financial sector.

Gregg started out as an Engineer and brings a rigorous thinking to his financial research. Gregg's passion for finance resulted in the creation of a real-time quote system and his work has been featured nationally in publications, such as the Investment Guide magazine.

As an avid researcher, Gregg concentrates on leveraging what institutional and big money players are doing to move the market and create seasonal trend patterns. Using custom research tools, Gregg identifies stocks that are optimal for stock and options traders to exploit these trends and find the tailwinds that can propel stocks to levels that are hidden to the average trader.

The content on any of Market Tamer websites, products, or communication is for educational purposes only. Nothing in its products, services, or communications shall be construed as a solicitation and/or recommendation to buy or sell a security. Trading stocks, options, and other securities involve risk. The risk of loss in trading securities can be substantial. The risk involved with trading stocks, options and other securities are not suitable for all investors. Prior to buying or selling an option, an investor must evaluate his/her own personal financial situation and consider all relevant risk factors. See: Characteristics and Risks of Standardized Options (http://www.optionsclearing.com/publications/risks/riskstoc.pdf). The www.MarketTamer.com educational training program and software services are provided to improve financial understanding.

Related Posts