Can someone please explain to me why it is never a good idea to exercise American Call options before expiration? I have read the CFAI text, Schweser and bunch of stuff online and I have no idea…please help… I ehat derivatives…
I think you are getting confused. Read below: A)If the cash flow is zero= no dividend --> Then it will be never optimal to exercise the American Option before maturity (European and American Call option will have the same lower bound) B) If the cash flow is different from zero= the underlying asset is paying dividends—> It is optimal to exercise the American option just before the the dividend is paid (as when the divided is paid the price of underlying asset will go down and hence the price of the American call option)
This is because you would limit your upside price appreciation. If the stock is already in the money and you forsee the price going higher, exercising the option would be pointless. For instance, if you have an option with a strike price of $20 and the stock is selling for 30, you would locked in your profit of $10 instead of allowing the potential stock price to rise above $30. This statement requires some judgement however (as does all CFA statements).
american call price consists of two components: intrinsic value (how much you’d get if you excercise it) and time value. Since time value is non-negative, you’d be better off selling the option rather than excercising.
maratikus Wrote: ------------------------------------------------------- > american call price consists of two components: > intrinsic value (how much you’d get if you > excercise it) and time value. Since time value is > non-negative, you’d be better off selling the > option rather than excercising. Maratikus, what you said it is a bit too generic, you should also consider what I have written above.
strangedays - yep (except “might be optimal”) getterdone - nope. Exercising an American call early has nothing to do with your expectation of the price going higher. You can always exercise the option and make a new bet on the stock. So here’s the way I like to look at it: There are two components to the valuation of an option, intrinsic value and time value. Both of those are >= 0 always. If you exercise the call early, you are getting just the intrinsic value and blowing away the time value. If you feel like locking in your profits (which might be a good idea), you can always get more money by selling the call to someone else who wants the time value. This argument doesn’t work for puts because the stock has a floor. Thus, if the stock drops to 0 there is nothing better that can happen to you than has already happened so the time value is 0. Exercising the put then gives you a bunch of money you can put in the bank and earn interest on.
strangedays, i wrote generic stuff. I almost agree with your statement though it’s important to compare PV of dividends and time value.
strangedays Wrote: ------------------------------------------------------- > maratikus Wrote: > -------------------------------------------------- > ----- > > american call price consists of two components: > > intrinsic value (how much you’d get if you > > excercise it) and time value. Since time value > is > > non-negative, you’d be better off selling the > > option rather than excercising. > > > Maratikus, what you said it is a bit too generic, > you should also consider what I have written > above. He knows that already…
JoeyDVivre Wrote: ------------------------------------------------------- > strangedays Wrote: > -------------------------------------------------- > ----- > > maratikus Wrote: > > > -------------------------------------------------- > > > ----- > > > american call price consists of two > components: > > > intrinsic value (how much you’d get if you > > > excercise it) and time value. Since time > value > > is > > > non-negative, you’d be better off selling the > > > option rather than excercising. > > > > > > Maratikus, what you said it is a bit too > generic, > > you should also consider what I have written > > above. > > He knows that already… I just wanted that other people dont get confused…nothing more. I know Maratikus is very good!
Thanks for the clarification Joey, working on options now, my weakest subject and trying to beef up on it!
Thanks for the responses everyone…just a few more questions and I should have this cleared up… So the time value really refers to the speculative nature of the underlying stock/asset? correct? Because you would want to hold on to the option in hopes that the asset price shoots up and it is worth later than now? Also, as the sky is limit for profits for an american call it is worth holding on in hopes of price increasing even more? While for an american put, the most the price can go down to is zero so it might be worth to exercise early as JDV stated earlier?
BluCollar, it is very unusual the early exercise of American call options. this is because any option has a non-negative time value and is usually worth more unexercised. In this case, the holder of the option prefer to sell it rather than exercise it prior maturity (as it would sacrifice the time value). Where an American and a European option are otherwise identical (same strike, underlying… etc) the American option will be worth at least as much as the European. In addition, as explained above, the early exercise of an American call option may be optimal in this situation: - If the call option is in the money (the delta goes close to 1 as the call goes close to maturity) it is often exercised just before the stock pays a dividend which would lower its value by more than the option’s remaining time value I hope this help
BlueCollarHero Wrote: ------------------------------------------------------- > Thanks for the responses everyone…just a few > more questions and I should have this cleared > up… > > So the time value really refers to the speculative > nature of the underlying stock/asset? correct? If speculative means variable, yes. > Because you would want to hold on to the option in > hopes that the asset price shoots up and it is > worth later than now? You or someone else. You have to be able to sell it for more than it’s intrinsic value because you would rather have a call + bond than the stock and people are paying the strike + intrinsic value for the stock. > Also, as the sky is limit > for profits for an american call it is worth > holding on in hopes of price increasing even > more? > Yep > > While for an american put, the most the price can > go down to is zero so it might be worth to > exercise early as JDV stated earlier? Yep
great, thanks for the quick responses everyone…really appreciate it…
simple answer: if you exercise early you own the stock but why would you own the stock when you can own the call and have no downfall (say the next day the stock drops to 0). Well what about if you exercise the call and then sell the stock and make the difference? -You wouldn’t do this because you can just sell the call for more money than the difference between the strike price and the exercise price (a calls minimum value is this difference) 
“CFA level 1- It’s not a test it’s a way of life”
“There are two components to the valuation of an option, intrinsic value and time value. Both of those are >= 0 always. If you exercise the call early, you are getting just the intrinsic value and blowing away the time value. If you feel like locking in your profits (which might be a good idea), you can always get more money by selling the call to someone else who wants the time value” PERFECTLY stated. It isnt even stated this clearly in finance textbooks.
Yes I agree. Also imagine, you can also exercise the call in the future at expiration, if you exercise at expiration, you earn interest on your funds by holding it between now and expiration.