You have a couple different points in this comment Ugur so why don’t I address the one about early exercise.
Just because the stock goes up and the option is now in-the-money doesn’t necessarily mean the option will get exercised right away. In-the-money options have two components to their premium, a time premium and intrinsic value. The intrinsic value is based upon how much the option would be worth if it were exercised today. For example a March 35 call with the stock trading at 36 would have an intrinsic value of $1 (36 – 35). However, if there is still time left until expiration, the option might be trading in the marketplace at $2 or $3. Why would you exercise the option and receive $1 when you could sell it in the marketplace for $2 or $3? In this case, the extra value of the option above the $1 intrinsic value is the time premium. So it is usually not optimal to exercise the option that has additional time premium (unless there is a dividend or corporate event coming – we can save this for another day).
Another factor against someone exercising a call option early is that by doing so you are in reality selling a put… Initially, this may be a bit counterintuitive but let’s take a look. If you bought the March 35 call at $2 with the stock at 36, the most you would lose is $2 (the amount you paid for the option). Even if the stock goes to 0, if you are the owner of the call option at $2 that is the most you can lose. If you exercise the call option, you now own the stock. What happens if the stock goes to 0 now? By exercising the call option early you now have risk below 35 just like you would if you had sold the March 35 put.
In my experience, clients get very nervous when their covered call position goes in-the-money (especially if it is low basis stock). But by carefully monitoring the position, and checking the amount of time premium left in the option, you can usually avoid early exercise situations and complete some adjustment strategies (such as rolling to another expiration or higher strike price) to avoid having the stock called away.
Thanks again for your comments Ugur, and please let me know if you have any additional insights…
Bud Haslett, CFA