Risk of assignment before expiration due to dividend

BMK

BMK

On Aug. 3, we put on a bull call spread in TGT:

Long 126 Call (Exp 08/21)
Short 128 Call (Exp 08/21)

for a net debit of $0.99

At that time, the stock was trading around 128. It has since risen dramatically. As I write this, it is trading around 136.

So everything looks good, right? The spread should produce the max profit, which in this case is $1.01.

But we overlooked the fact that the stock goes ex-dividend on Aug. 18. The dividend is .68 per share. Yes, we should have checked this before buying the spread. But here we are.

It seems very likely that the short leg will get exercised in the next few days, resulting in a short stock position in which we will have to pay the dividend.

What would you do?
  • Unwind the position right now?
  • Exercise the long leg right now?
  • Do nothing?
  • Or something else?
If we unwind the position right now, we won't get $2.00 for the spread. Despite the fact that both legs are deep in the money, the options are not trading at parity. (Ya think that might have something to do with that upcoming dividend? LOL) As I write this, the current bid for the spread is $1.15.

And to make things more interesting, there is an earnings announcement scheduled for Aug. 19, before the market opens. (We knew about this when we bought the spread.)

BMK
 
A few things,

As of right now with TGT trading 136.45, your spread is worth about 1.60, which means if you enter an order to sell it now you will probably get no lower then 1.55.

Right now your short leg is not at risk of assignment. The 128 put is trading about 1.25. As long as this put is worth more than the dividend, your the call shouldn't be exercised. If it is it would be good for you.

If the 126 put is trading below the the dividend amount, you should exercise your long 126 calls (if you have the money to cover the trade) You could then buy the 126 puts and have an almost risk free trade.

The easiest thing for you to do would be just to sell the spread out if either or both of your legs should be exercised. If thats the case you spread will be worth closer to 2 as well.
 
FSU said:
Right now your short leg is not at risk of assignment. The 128 put is trading about 1.25. As long as this put is worth more than the dividend, your the call shouldn't be exercised.
More...

Thanks for your input. I would like to get a better understanding of your reasoning. I don't see exactly how the price of the put influences whether an early exercise takes place.

My understanding is that the assignment process is random, meaning anyone holding a long 128 call that chooses to do an early exercise could be assigned to me because I am short that contract. In other words, an assignment does not hinge on a decision made by the party that bought the 128 call that I sold on August 3. It could be anyone currently holding a 128 call.

So let's assume for this discussion that someone out there is holding some 128 calls as a straight long position, that is not part of a spread or anything else. As we get closer to the ex-dividend date of Aug. 18, isn't it possible, and indeed rather likely, that at least some of the folks holding those calls will choose to do an early exercise in order to earn the dividend, regardless of the price of the 128 put?

If the holder of a 128 call is planning to buy and hold the stock, why wouldn't they choose to exercise a few days early in order to get the dividend?

BMK
 
A Long call is synthetically equal to long stock and long put (of the same strike). This is why the price of the put matters. So If I am long the 8/21 128 call, if I exercise it and buy the put, I would synthetically have the same position as before, a long call (there is also some cost of carry considerations as well.) If I can buy the put for less then the dividend, I now have the same position synthetically as I had before, but for a better price.

If the price of the put is higher then the dividend, I would lose money when I did this.

If you wanted the dividend you would then be better off selling your 128 call and buying the stock. If you exercised it, you would lose any extrinsic value it had left and there would be extrinsic value if the put was higher then the dividend.

Assignments are randomly given to firms by the OCC. They firms then give them to customers in a manner that they have filed (random, etc)
 
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