What Happens When Options Are Exercised?

To understand the idea behind the Covered Call ETF, it is important to understand the difference between a call option that is exercised by the holder and a call option that the holder decides not to exercise.

goldWe can assume that the holder of a call option wants to make money, and will only elect to exercise the call option when the market price of the underlying (such as 1 Apple share or 1 bar of gold) is higher than the strike price of the call option. The strike price is the price that the option holder must pay the issuer of the call option in order to exercise the option.

If the market price of the underlying is the same or lower than the strike price, there is no reason for the call option holder to exercise the option. The option will expire and the issuer of the covered call option can keep the underlying. This is of course the desired situation for the issuer of call option.

Today, it is rare for call options to actually result in delivery of the underlying. Instead, the issuer of the call option pays the holder of the call option the difference between the strike price and the market price when the holder of the option elects to exercise the option.

Buying back the call option instead

Instead of even getting to a point where the call option is exercised by the holder, the issuer can offer to buy back the call option from the holder of the option. This way, the holder can realize a profit before the option expires and the issuer doesn’t have to risk ending up in a situation where a call option holder demands actual deliver.

Covered Call ETFs are known to normally offer to buy back call options that (due to the market price and the strike price of the underlying) are likely to be exercised. By buying them back instead of letting the option holder exercise the option, the ETF can avoid having to actually sell the underlying. Selling the underlying can trigger capitals gains tax for the ETF (if the underlying was purchased for a lower price than the strike price). Also, selling the underlying will usually force the ETF to make a new purchase, at whatever market price, to follow the plan for the ETFs portfolio. This is especially true of the ETF is in some form trying to track an index.