April 28 (Bloomberg) -- Radio ShackCorp., the third-largest U.S. electronics retailer, plunged the most in almost six years after first-quarter profit fell more than analysts estimated on slowing sales of wireless-telephone plans.
RadioShack declined $2.35, or 13 percent, to $15.15 at 12:18 p.m. in New York Stock Exchange composite trading, the steepest drop since August 2002. The shares more than doubled in the year after Julian Day, a former Kmart Holding Corp. chief executive officer, took over RadioShack in July 2006. After peaking last June, the stock dropped 50 percent through last week.
Sales fell 4.4 percent, the seventh straight decline, and profit dropped for the first time in eight quarters. Day, who had previously bolstered earnings by cutting costs, failed to stem the deterioration in income from wireless phones and plans. Higher advertising costs also eroded profit.
``We're definitely seeing evidence the cuts are fading and now it's a revenue story,'' Scott Tilghman, an analyst with Soleil Securities Corp. in Baltimore, said in a telephone interview. ``We're not seeing profitable top-line growth.''
Profit dropped to $38.8 million, or 30 cents a share, from $42.5 million, or 31 cents, a year earlier, Fort Worth, Texas- based RadioShack said today in a statement. Sales declined 4.4 percent to $949 million. The shares fell 7.5 percent.
Profit included a gain of about 3 cents a share related to an income-tax issue in Puerto Rico, said Tilghman. Excluding that, profit was 27 cents, he said.
Analysts estimated earnings of 29 cents a share, the average of 16 projections in a survey by Bloomberg. The sales estimate was $945.2 million.
Revenue from less-profitable items, such as global- positioning devices, video game consoles and digital cameras, advanced.
Same-Store Sales
Sales in stores open at least 12 months fell 4 percent, less than some analysts estimated. Rick Weinhart, an analyst with BMO Capital Markets Corp., predicted an 8 percent drop in a research note April 22. Horvers expected a decline of 4.6 percent. Sales in such stores, a measure of retailer health because it discounts the effect of new stores, have dropped for nine straight quarters.
Growth in wireless sales, which make up about a third of revenue, fell after RadioShack switched to AT&T Inc. plans from Verizon Wireless in 2006. Fewer sales of Sprint wireless plans contributed to the sales decline, RadioShack said today.
Sales trends improved in the quarter, Day said in the statement. Same-store sales fell an average of 1.2 percent in February and March.
Gross margin, the share of sales after subtracting the cost of goods sold, narrowed to 47.4 percent from 49.9 percent on sales of less-profitable items and more advertising, the company said.
To contact the reporter on this story: Mark Clothier in Atlanta at mclothier@bloomberg.net
Monday, April 28, 2008
Sweet Life
In the high-price world of finance it is not often that market Titans often come together and we all smile; enter the Candy Man AKA Warren Buffet. Through the sweet financial matchmaking of Berkshire Hathaway, chocolate king Mars (a family owned business) is set to acquire the Govenor of Gun Wrigley. What makes Wrigles such a tasty target, simple: margins. Wrigley gets 47% of its profit form overseas, and controls allmost 20% of the gum market share internationally.
People familiar with the matter tell The Wall Street Journal Mars is set to pay more than $22 billion for Wrigley and could announce the transaction as early as today. Such a price from the producer of Snickers bars and M&M's for the maker of Juicy Fruit would be a tasty bonus for shareholders of Wrigley, whose stock market value is about $17.3 billion, and the Journal says the buyers were prepared to stomach such a rich premium. Berkshire, in providing financing for Mars, would become a stakeholder in Wrigley. Closely held Mars has long been admired by Mr. Buffett, who, as the Journal points out, "is famous for confidence in the staying power of iconic consumer brands such as Coca-Cola."
The deal "would remake the global confectionery landscape," offering Mars a more global reach since "Wrigley generates the majority of its sales outside of the U.S," the Journal adds. Mars, with a 15% global market share, is already the biggest seller of chocolate. Among the other candidates for consolidation that may now feel pressured to join forces are Hershey and Cadbury Schweppes, which discussed a deal last year but didn't find a way to make it work, the Journal notes.
Expect stock for both to rise behind this announcement.
People familiar with the matter tell The Wall Street Journal Mars is set to pay more than $22 billion for Wrigley and could announce the transaction as early as today. Such a price from the producer of Snickers bars and M&M's for the maker of Juicy Fruit would be a tasty bonus for shareholders of Wrigley, whose stock market value is about $17.3 billion, and the Journal says the buyers were prepared to stomach such a rich premium. Berkshire, in providing financing for Mars, would become a stakeholder in Wrigley. Closely held Mars has long been admired by Mr. Buffett, who, as the Journal points out, "is famous for confidence in the staying power of iconic consumer brands such as Coca-Cola."
The deal "would remake the global confectionery landscape," offering Mars a more global reach since "Wrigley generates the majority of its sales outside of the U.S," the Journal adds. Mars, with a 15% global market share, is already the biggest seller of chocolate. Among the other candidates for consolidation that may now feel pressured to join forces are Hershey and Cadbury Schweppes, which discussed a deal last year but didn't find a way to make it work, the Journal notes.
Expect stock for both to rise behind this announcement.
Wednesday, April 23, 2008
Sunny Side Up
A few months back we predicted the decline in the price of oil, and right now we look dead wrong. That's OK, because the SUN will have its day to shine, and very soon.
The introduction of nanotechnology is allowing scientist to double the output of solar photovoltaics every 3 years. If we were able to double output just 7 more times, the sun could provide all of the energy needed to run every appliance in the entire world.
What this means for investors is simply, invest in solar energy companies. Some of our favorites are Ausra and Aussy company that has some amazine new technologies; along with First Solar they are leading the way in the nano revolution.
The introduction of nanotechnology is allowing scientist to double the output of solar photovoltaics every 3 years. If we were able to double output just 7 more times, the sun could provide all of the energy needed to run every appliance in the entire world.
What this means for investors is simply, invest in solar energy companies. Some of our favorites are Ausra and Aussy company that has some amazine new technologies; along with First Solar they are leading the way in the nano revolution.
Sunday, April 20, 2008
Benz meets BMW
What does it say about our world when our automakers are better able to share inforomation then our government agencies? That said, this is a financial blog and not a political one. Irony, all of this good German good will is spurred by the Chinese.
BEIJING (AP) -- Daimler AG, the maker of Mercedes-Benz cars, is discussing sharing components and technology development with rival BMW AG, Daimler CEO Dieter Zetsche said Sunday.
The luxury automakers see each other as direct competitors and the possibility of cooperation reflects the intense pressure on automakers to cut costs amid slow sales growth in the United States and Europe. "We are discussing potentially sharing components. And this might make sense specifically in regard to new technologies," Zetsche told reporters at the Beijing auto show.
Daimler, based in Stuttgart, and BMW, in Munich, might consider jointly investing in basic research but no agreements have been reached, Zetsche said. He gave no other details.
China, the world's second-largest auto market, has been a bright spot for Daimler and other automakers, with overall sales forecast to grow at least 15 percent this year. U.S. sales are expected to decline this year, while those in Europe and Japan are flat.
In China, Daimler says its first-quarter sales soared 42 percent from the same period last year to 8,661 vehicles. The company says China is the No. 2 market for its S-class sedans after the United States, accounting for one-third of sales.
If this sticks this will be big news on the international equities market. Much like the airlines environment of M&A, this is a tech version on the other side of the world. The ability to take advantage of economies of scale is bound to cut overhead cost, for both manufactures; the question is will each manufactures be able to maintain its own unique identity. As you may recall Dodge and Mitusbschi did this is the mid 90s and both suffered.
Thursday, April 17, 2008
Go Go Gadget Google
Investors will be eyeing Google (GOOG) today after the closing bell, as the online search specialist reports first quarter earnings. Analysts are expecting net income of $4.52 per share, 22.8% higher than the same period a year ago. Revenue is expected to come in at $3.61 billion, up 6.5% from the fourth quarter of 2007.
Most companies would kill for that sort of expansion given current economic conditions, but Google's growth clip is off significantly from previous levels. First quarter earnings in 2007 were a whopping 60.6% higher than 2006 numbers, which were almost twice that of 2005.
According to the company, Google generates 44% of its revenue from overseas. Investors should welcome this trend, as online growth rates begin to cool in the U.S. Abroad, however, Internet use is still expanding rapidly.
In recent months, much has been made about Google's relative susceptibility to the continuing economic slowdown. The company doesn't provide formal earnings guidance, and according to The Wall Street Journal analysts rely heavily on data compiled by ComScore, a compiler of online clicking habits. On Tuesday, ComScore reported that, compared to the fourth quarter of last year, first quarter clicks on Google search ads declined 9.3%.
Some investors fear Google has saturated its primary market -- online search --- and is now more exposed to oscillations in economic activity. Small and medium-sized businesses are already scaling back advertising campaigns, eating into Google's bottom line. CEO Eric Schmidt maintains his company's results aren't closely tied to greater economic strength or weakness. Meanwhile, skeptics accuse the company of failing to generate revenue from its forays into other markets, like online document sharing, email and word processing applications.
Most companies would kill for that sort of expansion given current economic conditions, but Google's growth clip is off significantly from previous levels. First quarter earnings in 2007 were a whopping 60.6% higher than 2006 numbers, which were almost twice that of 2005.
According to the company, Google generates 44% of its revenue from overseas. Investors should welcome this trend, as online growth rates begin to cool in the U.S. Abroad, however, Internet use is still expanding rapidly.
In recent months, much has been made about Google's relative susceptibility to the continuing economic slowdown. The company doesn't provide formal earnings guidance, and according to The Wall Street Journal analysts rely heavily on data compiled by ComScore, a compiler of online clicking habits. On Tuesday, ComScore reported that, compared to the fourth quarter of last year, first quarter clicks on Google search ads declined 9.3%.
Some investors fear Google has saturated its primary market -- online search --- and is now more exposed to oscillations in economic activity. Small and medium-sized businesses are already scaling back advertising campaigns, eating into Google's bottom line. CEO Eric Schmidt maintains his company's results aren't closely tied to greater economic strength or weakness. Meanwhile, skeptics accuse the company of failing to generate revenue from its forays into other markets, like online document sharing, email and word processing applications.
Monday, April 14, 2008
Buy low, Sell high
While the old addage still stands true, in this turbulant time its becoming harder to apply traditional fundamentals to the equities market(s). So what can you use as your guide - Greed. That's right, let that little voice in the back of my mind be your guide.
A great example of the big G. Just a few months ago Google was selling at around $700 per share. Had you bought the stock at $400 a share your eyes should have been green with glee.
When looking at your short-term investments (no matter if its long-terms that have come due or a day trade) its a good idea to set some buy/sell limits for yourself. A very simple way is to say -5% and +10%. This way you are in there long enough that you can weather a small storm or you stick around until right before the bubble burst. Its never a good idea to trade on emotion.
Some strong sectors that should bring some solid returns are: aerospace/defense, manufacturing (especially TVs and DvD players), and AOL. While AOL isn't a sector its deal with Verizon, combined with the restructuring makes them a good value pick.
Stay away from companies that are heavy in the export business, the weak dollar is slowing cutting into already slim margins. Restaurants, blame it on the rain or maybe the lack of it. Fuel prices and crop shortages are leading to increased food cost. The problem is that with families pocketbooks being tight its hard to raise prices. A silver lining may be Applebees, Ruby Tuesday, and Red Lobster. Some builders and their suppliers... Need I say more.
A great example of the big G. Just a few months ago Google was selling at around $700 per share. Had you bought the stock at $400 a share your eyes should have been green with glee.
When looking at your short-term investments (no matter if its long-terms that have come due or a day trade) its a good idea to set some buy/sell limits for yourself. A very simple way is to say -5% and +10%. This way you are in there long enough that you can weather a small storm or you stick around until right before the bubble burst. Its never a good idea to trade on emotion.
Some strong sectors that should bring some solid returns are: aerospace/defense, manufacturing (especially TVs and DvD players), and AOL. While AOL isn't a sector its deal with Verizon, combined with the restructuring makes them a good value pick.
Stay away from companies that are heavy in the export business, the weak dollar is slowing cutting into already slim margins. Restaurants, blame it on the rain or maybe the lack of it. Fuel prices and crop shortages are leading to increased food cost. The problem is that with families pocketbooks being tight its hard to raise prices. A silver lining may be Applebees, Ruby Tuesday, and Red Lobster. Some builders and their suppliers... Need I say more.
Wachovia slumps
CHARLOTTE, N.C. (AP) -- Wachovia Corp. will slash its dividend and raise $7 billion in a share sale after reporting a surprise first-quarter loss on Monday of $393 million. The company's shares fell more than 10 percent.
The nation's No. 4 bank, whose results were tainted by exposure to the troubled credit markets, also said it plans to cut 500 jobs in its corporate and investment bank.
"I'm deeply disappointed with our first-quarter results," Chief Executive Ken Thompson told analysts on a conference call. "I know these actions aren't without cost. I wish they weren't necessary, but they are."
The Charlotte-based bank's loss works out to 20 cents a share. That compared with profit of $2.3 billion, or $1.20 a share, a year earlier. Excluding merger-related and restructuring charges, the bank lost $270 million, or 14 cents a share.
Revenue fell 4.5 percent to $7.89 billion from $8.27 billion last year.
Analysts surveyed by Thomson Financial had expected Wachovia to earn 40 cents per share on revenue of $7.98 billion. The earnings estimates typically exclude one-time items.
Wachovia said it will cut its dividend by 41 percent to 37.5 cents per share from 64 cents per share. The move is expected to save $2 billion annually in order "to build capital ratios and provide more operational flexibility," it said.
The bank also said it plans to cut more jobs within its corporate and investment bank, an area that has been hit by a drop in issuance of complex securities. Since October, Wachovia has cut more than 260 jobs in corporate and investment banking, which had about 6,100 employees as of Dec. 31.
Shares in Wachovia fell $2.96, or more than 10 percent, to $24.85 on Monday.
Wachovia is part of a long list of companies that have raised capital in the wake of problems in the mortgage market, including Countrywide Financial Corp., Thornburg Mortgage Inc., Merrill Lynch & Co., Morgan Stanley and Citigroup Inc.
Its share sale will involve 145.8 million shares of common stock at $24 each, raising roughly $3.5 billion. Wachovia also expects net proceeds from a convertible preferred stock offering of about $3.4 billion. The bank said it intends to use the money it raises from the sale for general corporate purposes.
The nation's No. 4 bank, whose results were tainted by exposure to the troubled credit markets, also said it plans to cut 500 jobs in its corporate and investment bank.
"I'm deeply disappointed with our first-quarter results," Chief Executive Ken Thompson told analysts on a conference call. "I know these actions aren't without cost. I wish they weren't necessary, but they are."
The Charlotte-based bank's loss works out to 20 cents a share. That compared with profit of $2.3 billion, or $1.20 a share, a year earlier. Excluding merger-related and restructuring charges, the bank lost $270 million, or 14 cents a share.
Revenue fell 4.5 percent to $7.89 billion from $8.27 billion last year.
Analysts surveyed by Thomson Financial had expected Wachovia to earn 40 cents per share on revenue of $7.98 billion. The earnings estimates typically exclude one-time items.
Wachovia said it will cut its dividend by 41 percent to 37.5 cents per share from 64 cents per share. The move is expected to save $2 billion annually in order "to build capital ratios and provide more operational flexibility," it said.
The bank also said it plans to cut more jobs within its corporate and investment bank, an area that has been hit by a drop in issuance of complex securities. Since October, Wachovia has cut more than 260 jobs in corporate and investment banking, which had about 6,100 employees as of Dec. 31.
Shares in Wachovia fell $2.96, or more than 10 percent, to $24.85 on Monday.
Wachovia is part of a long list of companies that have raised capital in the wake of problems in the mortgage market, including Countrywide Financial Corp., Thornburg Mortgage Inc., Merrill Lynch & Co., Morgan Stanley and Citigroup Inc.
Its share sale will involve 145.8 million shares of common stock at $24 each, raising roughly $3.5 billion. Wachovia also expects net proceeds from a convertible preferred stock offering of about $3.4 billion. The bank said it intends to use the money it raises from the sale for general corporate purposes.
Wednesday, April 9, 2008
C stock fall
Reports that Citigroup is taking steps to get some bad debt off its books had the markets poised for gains, but more worries about first-quarter earnings season and an outline by the Fed for future economic meltdowns crept into the markets.
The banking giant, which has been slammed by the subprime-mortgage meltdown, is close to a deal that would sell $12 billion of highly leveraged loans and bonds to private-equity firms Apollo Management, TPG Capital and Blackstone Group, according to published reports.
The buyers reportedly will pay just under 90 cents on the dollar for the securities. Shares of Citi, a Dow stock, rose 26 cents, or 1.1%, to $24.02 in morning trading.
The banking giant, which has been slammed by the subprime-mortgage meltdown, is close to a deal that would sell $12 billion of highly leveraged loans and bonds to private-equity firms Apollo Management, TPG Capital and Blackstone Group, according to published reports.
The buyers reportedly will pay just under 90 cents on the dollar for the securities. Shares of Citi, a Dow stock, rose 26 cents, or 1.1%, to $24.02 in morning trading.
Monday, April 7, 2008
Hello Moto
CHICAGO (AP) -- Motorola Inc. settled its proxy battle with Carl Icahn on Monday, agreeing to back two of the billionaire investor's nominees for its board of directors in exchange for him dropping litigation against the cell phone maker.
The agreement avoids a showdown at the company's upcoming annual meeting for what would have been the second straight year.
Motorola named Keith Meister, a managing director of Icahn investment funds, to its board and said it will nominate both him and fellow Icahn nominee William Hambrecht for director slots. The agreement virtually ensures that both will be elected at the company's shareholder meeting next month.
Schaumburg, Ill.-based Motorola also will seek input from Icahn on the planned separation of its mobile devices operations and search for a chief executive for that business under the terms of the agreement.
Icahn agreed not to solicit proxies at the annual meeting, to dismiss litigation against the company and to vote his shares in support of all of the board's director nominees.
Motorola still faces an uphill challenge with its troubled cell phone unit but said it was pleased to have reached the agrement with Icahn."We believe that this matter has been resolved in a manner that serves the best interests of our shareholders and prevents a costly and distracting proxy contest," Motorola spokeswoman Jennifer Erickson said. "We and Mr. Icahn share a common interest in positioning all of our businesses to deliver an enhanced shareholder value."
Shares in the company rose 14 cents to $9.81 in morning trading Monday.
The agreement avoids a showdown at the company's upcoming annual meeting for what would have been the second straight year.
Motorola named Keith Meister, a managing director of Icahn investment funds, to its board and said it will nominate both him and fellow Icahn nominee William Hambrecht for director slots. The agreement virtually ensures that both will be elected at the company's shareholder meeting next month.
Schaumburg, Ill.-based Motorola also will seek input from Icahn on the planned separation of its mobile devices operations and search for a chief executive for that business under the terms of the agreement.
Icahn agreed not to solicit proxies at the annual meeting, to dismiss litigation against the company and to vote his shares in support of all of the board's director nominees.
Motorola still faces an uphill challenge with its troubled cell phone unit but said it was pleased to have reached the agrement with Icahn."We believe that this matter has been resolved in a manner that serves the best interests of our shareholders and prevents a costly and distracting proxy contest," Motorola spokeswoman Jennifer Erickson said. "We and Mr. Icahn share a common interest in positioning all of our businesses to deliver an enhanced shareholder value."
Shares in the company rose 14 cents to $9.81 in morning trading Monday.
Thursday, April 3, 2008
C-IT drop
Thursday to scrap its student loan business comes as speculation of a buyout for the troubled commercial finance company grows. Student loans have taken a hit over the past few months, because as times get tough new grads cant afford to pay them.
CIT, which quit subprime mortgage lending last year, plans to sell some businesses in the first quarter while keeping its ``marquee'' units intact ``as much as possible,'' Chief Executive Officer Jeffrey Peek said in a conference call yesterday. The New York-based company drew on its entire $7.3 billion of emergency credit lines after being cut off from customary sources of cash.
CIT's shrinking access to cash adds to evidence that the credit crunch -- which already has claimed Bear Stearns Cos. and Countrywide Financial Corp. -- isn't responding to the Federal Reserve's effort to encourage more lending. The ``protracted disruption'' in capital markets may force Peek's company to find a ``strategic'' partner that can provide funding, he said.
The lender had its biggest drop in almost six years of New York Stock Exchange trading yesterday before a mid-session halt to announce that the company had tapped its credit lines. CIT closed down $2.01, or 17 percent, at $9.63. The shares fetched more than $61 last June.
Bond prices
The company's $500 million issue of 5.6 percent notes due in 2011 slumped to as low as 66.5 cents on the dollar, according to Trace, the Financial Industry Regulatory Authority's bond- pricing service. CIT has $2.8 billion of commercial paper due this year and $8.2 billion of other debt.
CIT may also have more than $4 billion of holdings tied to subprime mortgages, according to a March 17 report by Standard & Poor's. Subprime mortgages are made to people with weak credit, and record defaults on the loans helped trigger the global credit rout.
The New York-based finance company has been rattled since last month, suffering a series of setbacks due to its exposure to risky subprime mortgages. On March 19, Fitch Ratings placed the issuer default rating and debt ratings of CIT Group on a negative rating watch.
Oh yeah, and CIT also provided financing to ATA Airlines. The airline declared bankruptcy Thursday. CIT is the largest independent commercial finance company and was spun off from Tyco International in 2002. Shares have lost 73% of their value over the last 52 weeks and the stock is currently trading down 6 cents to $14.09.
CIT, which quit subprime mortgage lending last year, plans to sell some businesses in the first quarter while keeping its ``marquee'' units intact ``as much as possible,'' Chief Executive Officer Jeffrey Peek said in a conference call yesterday. The New York-based company drew on its entire $7.3 billion of emergency credit lines after being cut off from customary sources of cash.
CIT's shrinking access to cash adds to evidence that the credit crunch -- which already has claimed Bear Stearns Cos. and Countrywide Financial Corp. -- isn't responding to the Federal Reserve's effort to encourage more lending. The ``protracted disruption'' in capital markets may force Peek's company to find a ``strategic'' partner that can provide funding, he said.
The lender had its biggest drop in almost six years of New York Stock Exchange trading yesterday before a mid-session halt to announce that the company had tapped its credit lines. CIT closed down $2.01, or 17 percent, at $9.63. The shares fetched more than $61 last June.
Bond prices
The company's $500 million issue of 5.6 percent notes due in 2011 slumped to as low as 66.5 cents on the dollar, according to Trace, the Financial Industry Regulatory Authority's bond- pricing service. CIT has $2.8 billion of commercial paper due this year and $8.2 billion of other debt.
CIT may also have more than $4 billion of holdings tied to subprime mortgages, according to a March 17 report by Standard & Poor's. Subprime mortgages are made to people with weak credit, and record defaults on the loans helped trigger the global credit rout.
The New York-based finance company has been rattled since last month, suffering a series of setbacks due to its exposure to risky subprime mortgages. On March 19, Fitch Ratings placed the issuer default rating and debt ratings of CIT Group on a negative rating watch.
Oh yeah, and CIT also provided financing to ATA Airlines. The airline declared bankruptcy Thursday. CIT is the largest independent commercial finance company and was spun off from Tyco International in 2002. Shares have lost 73% of their value over the last 52 weeks and the stock is currently trading down 6 cents to $14.09.
Wednesday, April 2, 2008
Early Options
While the math behind options pricing models may seem daunting, the underlying concepts are not. 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.
The first three deservedly get most of the attention, because they have the largest effect on option prices. But it is also important to understand how dividends and interest rates affect the price of a stock option. It is also these two variables that are crucial to understanding when to exercise options early.
The Black-Scholes model
The first option pricing model, the Black-Scholes model, was designed to evaluate European-style options, where early exercise is not permitted. So Black and Scholes never addressed the problem of when to exercise an option early and how much the right of early exercise is worth. Being able to exercise an option at any time should theoretically make an American-style option more valuable than a similar European-style option, although in practice there is little difference in how you trade them.
Because stock options are American-style, and carry with them the right of early exercise, different models were developed to accurately price them. Most of these are refined versions of the Black-Scholes model, adjusted to take into account dividends and the possibility of early exercise. To appreciate the difference this can make, you first need to understand when an option should be exercised early.
The role of interest rates in determining when to sell early
The short answer as to when you should exercise an option early is: only when its theoretical value is exactly at parity and its delta is exactly 100. That may seem obtuse, but as we go through the effect interest rates and dividends have on option prices, I will also bring in a specific example to show when this occurs. First let's look at the effect interest rates have on option prices, and 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, you need to think about the effect of interest rates when comparing an option position to simply owning the stock. Since it is much cheaper to buy a call option than 100 shares of the stock, the call buyer is willing to pay more for the option when rates are relatively high, since he can invest the difference in the capital required between the two positions.
Interest rates have been steadily falling in the United States, to the point where the current Fed Funds target is down to 1.0%. With the short-term rates available to individuals of around 0.75 to 2.0%, interest rates have a minimal effect on option prices right now. This is likely to change in the future, and all the best option analysis models include interest rates in their calculations, using a "risk-free" interest rate such as US Treasury rates.
Interest rates 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. Determining exactly when this happens is difficult, since each individual has different opportunity costs, but it does mean that early exercise for a stock put option can be optimal at any time provided the interest earned becomes sufficiently great.
Another consideration: dividends
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.
Example
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
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 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.
Summary
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.
The first three deservedly get most of the attention, because they have the largest effect on option prices. But it is also important to understand how dividends and interest rates affect the price of a stock option. It is also these two variables that are crucial to understanding when to exercise options early.
The Black-Scholes model
The first option pricing model, the Black-Scholes model, was designed to evaluate European-style options, where early exercise is not permitted. So Black and Scholes never addressed the problem of when to exercise an option early and how much the right of early exercise is worth. Being able to exercise an option at any time should theoretically make an American-style option more valuable than a similar European-style option, although in practice there is little difference in how you trade them.
Because stock options are American-style, and carry with them the right of early exercise, different models were developed to accurately price them. Most of these are refined versions of the Black-Scholes model, adjusted to take into account dividends and the possibility of early exercise. To appreciate the difference this can make, you first need to understand when an option should be exercised early.
The role of interest rates in determining when to sell early
The short answer as to when you should exercise an option early is: only when its theoretical value is exactly at parity and its delta is exactly 100. That may seem obtuse, but as we go through the effect interest rates and dividends have on option prices, I will also bring in a specific example to show when this occurs. First let's look at the effect interest rates have on option prices, and 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, you need to think about the effect of interest rates when comparing an option position to simply owning the stock. Since it is much cheaper to buy a call option than 100 shares of the stock, the call buyer is willing to pay more for the option when rates are relatively high, since he can invest the difference in the capital required between the two positions.
Interest rates have been steadily falling in the United States, to the point where the current Fed Funds target is down to 1.0%. With the short-term rates available to individuals of around 0.75 to 2.0%, interest rates have a minimal effect on option prices right now. This is likely to change in the future, and all the best option analysis models include interest rates in their calculations, using a "risk-free" interest rate such as US Treasury rates.
Interest rates 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. Determining exactly when this happens is difficult, since each individual has different opportunity costs, but it does mean that early exercise for a stock put option can be optimal at any time provided the interest earned becomes sufficiently great.
Another consideration: dividends
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.
Example
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
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 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.
Summary
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.
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