Hey Guys, Please could you assist with the following: If the underlying makes no cash payments, American calls should not be exercised early. Recall that an American option must be worth at least as much as a European option. The extra value of an American option, if any, comes from the fact that it can be exercised immediately. However, an American call should not be exercised early if the underlying makes no cash payments during the life of the call. Why would this be true, if the underlying price of the call option moves past the exercise price the option is in the money, now the underlying price could easly drop under the exercise price again, so an early exercise shoudl be performed to lock in your gain, so why the above be true? Thanks
Because of “No Arbitrage”-reasons, a call is always worth at least S - PV(K) which is the present value of the potential payoff (no dividends). The inner value of the american call is S-K, which is lower, if interest rates are positiv. So the european call corresponding to the american one is worth more than what you get from exercising. So don’t exercise (you can sell the option).
I was confused on this as well, but I think that last sentence of Martin’s is what is really key. I was thinking you either exercise or don’t exercise, forgetting that you can sell the option, which would be the best choice of all!
Thanks guys, sure one could sell the option, but it clearly states that, an American call should not be exercised early if the underlying makes no cash payments during the life of the call. I’m sorry but i still dont understand, how could this be true. Perhaps it’s because i dont understand your formula, what does the “k” stand for ? PS…sorry slightly off the subject, the book keeps calculating formula’s with 365 and 360 day years, which one do we use?
> an American call should not be exercised early if the underlying makes no cash payments during the life of the call. I don’t agree with that statement either. Yes, you can sell the call if it’s in the money, but it is possible that someone prefers exercise followd immediately by a sell, either for commission purposes, or as is often the case, due to lack of liquidity in the options market. The transaction cost can be substantially less if you choose to excerise instead of straight sell of the option. So, unless I’m missing something here, I would say the statement “an American call should not be exercised early if the underlying makes no cash payments during the life of the call” is not a correct statement…
I think liquidity is a different issue. Of course, there can be situations when bid-ask spread can be huge. The statement talks about option fair price. Option fair price should be higher than its intrinsic value, because of its non-negative time value component. Disregarding bid-ask spread, it’s always better to sell an ITM option than to exercise it because of the time value component if there are no cash payments during the life of the call. Otherwise you’d have to compare present value of the cash payments and the time value component.
Dreary, whatcha messing with them fer? The “no exercise of American calls on non-dividend stocks prior to expiration” is always prefaced with those friction-free markets assumptions. Put enough friction in markets and you can come up with all kinds of wacky things you should do. For instance, there are only ten shareholders in a company and 1,000,099 shares. The top two shareholders have 500,000 shares apiece. I own 1 option with a strike of 10 but the stock is selling at 2. There is shareholder election in which JoeyDVivre is up for Chairman of the Board complete with his own company yacht and very attractive executive secretary. Both large shareholders are known to be 50/50 on the vote. Should I exercise early? Edit: On the original question, I agree with maratikus, of course.
Joey, in your example, if those two shareholders know of your critical position, they will either bribe you to sell them the option, or they will bid it up and you could sell it for thousands of dollars! Edit: On the original question, I still think the original statment, as is without prefacing it with your friction-free markets assumptions, is bad academics.
I’m still confused…but thanks anyways.
maratikus Wrote: ------------------------------------------------------- > Disregarding bid-ask spread, > it’s always better to sell an ITM option than to > exercise it because of the time value component if > there are no cash payments during the life of the > call. maratikus, can you expound on this a little please?
Let’s denote S - underlying K - strike price Call value = intrinsic value + time value, where intrinsic value = max(0, S-K). Actually time value is defined as option value - intrinsic value. Time value is non-negative (zero at expiration). If an option is excercised, the buyer receives only the intrinsic value portion. If an option is sold, the price exceeds the intrinsic value because of the non-negative time value.
Great, thanks maratikus!