The variables used to come up with a “fair value” for a stock option are the price of the underlying stock, volatility, time, dividends, and interest rates. While the first three deservedly get most of the attention, since they have the most effect on option prices, it is dividends and interest rates that affect when to exercise options early.

So when should you exercise an option early? The short answer is: When its theoretical value is exactly at parity and its delta is exactly 100. That may not seem like a very useful, or even understandable, answer. But as we look at the effect interest rates and dividends have on option prices, I will also bring in specific examples to show when this occurs.

**Interest Rates and Exercising Put Options Early**

First let’s summarize the effect interest rates have on option prices, and then explain how they can determine if you should exercise a put option early.

An increase in interest rates will drive up call premiums, and cause put premiums to decrease. To understand why, think about the difference between an option position and simply owning the stock. It is much cheaper to buy a call option than 100 shares of stock, so a call buyer is willing to pay more for the option when interest rates are high. That is because he can invest the difference in capital required between the two positions.

It is interest rates that are the critical factor in determining whether to exercise a put option early. A stock put option becomes an early exercise candidate anytime the interest that could be earned on the proceeds from the sale of the stock at the strike price is large enough. Since each individual investor has different opportunity costs, there is no single magic number that tells you when it is worth it. But early exercise for a stock put option is optimal at any time that the interest earned becomes sufficiently great.

How dividends affect early exercise is easier to pinpoint. Cash dividends affect option prices through their effect on the underlying stock price. Because the stock price is expected to drop by the amount of the dividend on the ex-dividend date, high cash dividends imply lower call premiums and higher put premiums.

While the stock price itself usually undergoes a single adjustment by the amount of the dividend, option prices anticipate that dividends will be paid in the weeks and months before they are announced. The dividends paid should be taken into account when calculating the theoretical price of an option and projecting your probable gain and loss when graphing a position. This applies to stock indices as well. The dividends paid by all stocks in that index (adjusted for each stock’s weight in the index) should be taken into account when calculating the fair value of an index option.

Dividends are critical to determining when it is optimal to exercise a stock call option early, so both buyers and sellers of call options should consider the impact of dividends. Whoever owns the stock as of the ex-dividend date receives the cash dividend, so owners of call options may exercise in-the-money options early to capture the cash dividend. That means early exercise makes sense for a call option only if the stock is expected to pay a dividend prior to expiration date.

Traditionally, the option would be exercised optimally only on the day before the stock's ex-dividend date. But recent changes in the tax laws regarding dividends now mean that it may be two days before now, if the person exercising the call plans on holding the stock for 60 days to take advantage of the lower tax for dividends. To see why this is, let’s look at an example (ignoring the tax implications since it changes the timing only).

Say you own a call option with a strike price of 90 that expires in two weeks. The stock currently trading at $100, and is expected to pay a $2.00 dividend tomorrow. The call option is deep in-the-money, and should have a fair value of 10 and a delta of 100. So the option has essentially the same characteristics as the stock. There are three possible choices of what to do:

Do nothing (hold the option).

Exercise the option early.

Sell the option and buy 100 shares of stock.

Which of these choices is best? If you hold the option, it will maintain your delta position. But tomorrow the stock will open ex-dividend at 98 after the $2.00 dividend is deducted from its price. Since the option is at parity, it will open at 8, the new parity price, and you will lose two points ($200) on the position.

If you exercise the option early and pay the strike price of 90 for the stock, you throw away the 10-point value of the option, and effectively purchase the stock at $100. When the stock goes ex-dividend, you lose $2 per share when it opens two points lower, but also receive the $2.00 dividend since you now own the stock.

Since the $2.00 loss from the stock price is offset by the $2.00 dividend received, you are better off exercising the option than holding it. That is not because of any additional profit, but because you avoid a two-point loss. You must exercise the option early just to ensure you break even.

What about the third choice, selling the option and buying stock? This seems very similar to early exercise, since in both cases you are replacing the option with the stock. The decision of which to do depends on the price of the option. In this example, we said the option is trading at parity (10) so there would be no difference between exercising the option early or selling the option and buying the stock.

But options rarely trade exactly at parity. Suppose your 90 call option is trading for more than parity, say $11.00? Now if you sell the option and purchase the stock you still receive the $2.00 dividend, and own a stock worth $98, but you end up with an additional $1.00 you would not have collected if you exercised the call.

Alternately, if the option is trading below parity, say $9.00, you want to exercise the option early, effectively getting the stock for $99.00 plus collecting the $2.00 dividend.

So the only time it makes sense to exercise a call option early is if the option is trading at, or below, parity, and the stock goes ex-dividend tomorrow.

While interest rates and dividends are not the primary factors affecting an options price, an option trader should be aware of their effects. In fact, the primary drawback I have seen to many of the option analysis tools available is that they use a simple Black Scholes model and ignore interest rates and dividends.

The impact of not adjusting for early exercise can be very large, since it can cause an option to seem undervalued by as much as 15%. When you are competing in the options market against other investors and professional market makers, it doesn’t make any sense to not use the most accurate tools available.

To see why this is, let's take the example of owning a 90 call that expires in two weeks on a stock that is currently trading at 100 and is expected to pay a $2.00 dividend tomorrow. If we looked at the Expand window in OptionVue 6, we would see it has a theoretical price of 10 and a delta of 100. Essentially, the option has the same characteristics as the stock. This leaves us with three possible choices of what to do:

1. Do nothing (hold the option)

2. Exercise the option early

3. Sell the option and buy 100 shares of stock.

Which of these choices is best? If you hold the option, it will maintain the delta position. But tomorrow the stock will open ex-dividend at 98 after the $2.00 dividend is deducted from its price. Since the option is at parity, it will open at 8, the new parity price, and you will lose two points on the position.

If you exercise the option early and pay the strike price of 90 for the stock, you throw away the 10-point value of the option, and effectively purchase the stock at 100. When the stock goes ex-dividend, you lose $2 per share when it opens two points lower, but also receive the $2.00 dividend since you now own the stock. The $2.00 loss from the stock price is offset by the $2.00 dividend received. You are better off exercising the option than holding it, not because of additional profit, but because you avoid a two-point loss. You must exercise the option early to ensure you break even.

What about the third choice, selling the option and buying stock? This seems very similar to early exercise, since in both cases you are replacing the option with stock. The decision of which to do depends on the price of the option.

If the option is trading at parity, in this case 10, there is no difference between exercising the option early or selling the option and buying the stock. But suppose your 90 call is trading for more than parity, say $11.00? Now if you sell the option and purchase the stock you still receive the $2.00 dividend, and own a stock worth $98, but you end up with an additional $1.00 you would not have collected if you exercised the call. Alternately, if the option is trading below parity, say $9.00, you want to exercise the option early, effectively getting the stock for $99.00 plus collecting the $2.00 dividend.