covered writes and dividends

I read your article on covered call writing and have a question.  Your article says that if I write a call I'm
still entitled to the dividend.  That being the case, I have an example I'd like to go through with you.

Frontline LTD (FRO) closed at $42.74 yesterday.  The call for 35 in June (FROFH) is trading at $7.50.  If I buy 100
shares of Frontline and wrote the call immediately I should still get the dividend that happens next month.  Say that
dividend is $2 like last March... that means I will have made 2+7.5+35-42.74 or $1.76 per share.

Since the exercise value is much lower then it's current price (even adjusted for the drop on the ex-dividend date)
it almost certain to be exercised.

At first this plan seems like an automatic 4% gain... so that can't be right...  I then started reading about calls
being exercised before the strike date.  So say somebody comes along and exercises their call the day before the
ex-dividend date to capture the dividend.  I then lose 42.74-35-7.5 or $0.24 per share.

I haven't read anything about the behavior of a call as it approaches the ex-dividend date.  What's likely to happen as
the day approaches?  Is it pretty much automatic that my call will be exercised and I'll be forced to sell the 100
shares before the ex-dividend date?


Hello Robert,

You are correct: 'that can't be right.'  It's a virtual certainty that anyone who is short the Jun 35 call will be assigned an exercise notice before the stock goes ex-dividend.  The only exception occurs occasionally when a careless individual investor owns a small number of those call options and forgets to exercise.  But don't count on that possibility.  It does happen, but too infrequently for you to spend time and effort hoping to capture the dividend.

There is an important point that must be mentioned.  When you buy the stock @ $42.74, then the intrinsic value of the Jun 35 call is $7.74 and selling for only $7.50 is a foolish thing to do.  As you indicated in your discussion above, the most likely outcome for this trade is losing $24 per 100 shares - and that loss occurs because that call option was sold below parity (below its intrinsic value).  If you were to get $7.75 for the call, then you would have a tiny (very tiny) chance of not being assigned an exercise notice - and if you were assigned early, you loss would be only the commissions you paid to trade.  But when you sell at 24 cents under parity, it's just a bad trade.

Bottom line: The covered call writer is entitled to the dividend, unless the call owner exercises that call before the stock goes ex-dividend.