What is Early Exercise?
Early exercise of an options contract is the process of buying or selling shares of stock under the terms of that option contract before its expiration date. For call options, the options holder can demand that the options seller sell shares of the underlying stock at the strike price. For put options it is the converse: the options holder may demand that the options seller buy shares of the underlying stock at the strike price.
Early exercise is the process of buying or selling shares under the terms of an options contract before the expiration date of that option.
Early exercise is only possible with American-style options.
Early exercise makes sense when an option is close to its strike price and close to expiration.
Applications of Early Exercise
Early exercise works only with American-style options contracts and not with European-style options contracts. This is because American-style options contracts can be exercised at any time up to the contract’s expiration date.
However, with European contracts, the options contract holder may only exercise on and only on the expiration date. It is why early exercise is impossible for European-style options contracts; exercise is not allowed at any time before the expiration date.
Early exercise is a very common exercise strategy when it comes to large quantities of in-the-money (ITM) call options. It is because there is a significant trading benefit associated with exercising ITM call options early, as it renders substantial profit margins.
Benefits of Early Exercise
There are certain circumstances under which early exercise may be advantageous for a trader:
For example, a trader may choose to exercise a call option that is deeply in-the-money (ITM) and is relatively near expiration. Because the option is ITM, it will typically have negligible time value.
Another reason for early exercise may be a pending ex-dividend date of the underlying stock. Since options holders are not entitled to either regular or special dividends paid by the underlying company, this will enable the investor to capture that dividend. It should more than offset the marginal time value lost due to an early exercise.
Early Exercise Example
Suppose an employee is awarded 10,000 options to buy company ABC’s stock at $10 per share. They vest after two years.
The employee exercises 5,000 of those options to purchase ABC’s stock, which is valued at $15, after a year. Exercising those options will cost $7,000 based on a federal AMT rate of 28%. However, the employee can reduce the federal tax percentage by holding onto the exercised options for another year to meet requirements for long-term capital gains tax.