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.
Key Takeaways
- 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.
- Employees of startups and companies can also choose to exercise their options early to avoid the alternative minimum tax (AMT).
Understanding Early Exercise
Early exercise is only possible with American-style option contracts, which the holder may exercise at any time up to expiration. WithEuropean-style optioncontracts, the holder may only exerciseon the expiration date, making early exercise impossible.
Most traders do not use early exercise for options they hold. Traders will take profits by selling their options and closing the trade. Their goal is to realize a profit from the difference between the selling price and their original option purchase price.
For a long call or put, the ownercloses a trade by selling, rather than exercising the option. Thistrade often results in more profit due to the amount oftime value remaining in the long option lifespan. The more time there is before expiration, the greater the time valuethat remains in the option. Exercising that option results in an automatic loss of that time value.
Benefits of Early Exercise
There are certain circ*mstances under which early exercise may be advantageous fora 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 isITM, itwill 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 and Employee Options
There is another type of early exercise that pertains to company awarded stock options (ESO) given to employees. If the particular plan allows, employeesmay exercise their awarded stock options before they becomefully vestedemployees. A person may choose this option toobtain a more favorable tax treatment.
However, the employee will have to foot the cost to buy the shares before taking full vested ownership. Also, any purchased shares must still follow the vesting schedule of the company's plan.
The money outlay of early exercise within a company plan is the same as waiting until after vesting, ignoring the time value of money. However, since the payment is shifted to the present, it may be possible to avoid short-term taxation and the alternative minimum tax (AMT). Of course, it does introduce the risk that the company may not be around when the shares are fully vested.
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.
FAQs
Benefits of Early Exercise
2. 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.
Why would you exercise a call option early? ›
Benefits of Early Exercise
2. 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.
What are the two reasons why the early exercise of an American call option? ›
Firstly, the time value of money suggests that waiting until the expiration date allows the option holder to potentially earn more money through interest. Secondly, even if interest rates are zero, exercising early would result in the opportunity cost of forfeiting any future price appreciation of the underlying stock.
Is it better to exercise an option or sell it? ›
Occasionally a stock pays a big dividend and exercising a call option to capture the dividend may be worthwhile. Or, if you own an option that is deep in the money, you may not be able to sell it at fair value. If bids are too low, however, it may be preferable to exercise the option to buy or sell the stock.
Is it ever optimal to exercise an American call option early? ›
For an American call or put, the decision to exercise or hold at any time t depends just on the time value t and the underlying stock value S(t). The exercise time τ is chosen to maximize the value of the option. For an American call (on a stock without dividends), early exercise is never optimal.
Is it worth exercising options early? ›
Potential tax savings at exercise
Early exercising allows you to purchase your stock options before they vest when the strike price and FMV are equal or negligible, so you trigger very little or no additional taxes when exercising.
How often do people exercise options early? ›
It is most common for options to be exercised close to or on the expiration date, but American-style options can be exercised early. It doesn't happen often, but certain intervening events can prompt investors who are long on calls or puts to go ahead with the transaction.
What is the best time to sell options? ›
The next important thing to remember is that the selling options strategy works best when the market of the stock or the stock market has been exhibiting a clear-cut trend. For example, if there is a steady bullish trend, then traders will make profits by being consistent with selling put options.
Do you lose the premium if you exercise an option? ›
If the option is never exercised, you keep the money. If the option is exercised, you still keep the premium but are obligated to buy or sell the underlying stock if assigned.
What happens if I don't exercise my call option? ›
If I don't exercise my call option, what will happen? With an options contract, you are not obligated to take any action. If the contract is not fulfilled by the due date, it automatically terminates. Any option premium you paid will be returned to the vendor.
Can I sell an option below strike price? Options that have value in the marketplace can be bought or sold at any time, whether the underlying price of the stock is below or above the options strike price.
What time do call options get exercised? ›
As the holder of an equity or ETF call option, you can exercise your right to buy the stock throughout the life of the option up to your brokerage firm's exercise cut-off time on the last trading day. Options exchanges have a cut-off time of 4:30 p.m. CT, for receiving an exercise notice.
Should you wait to exercise options? ›
By exercising your stock options early, you can get a head start on the one-year holding period. Longer holding period for capital gains tax: By starting your holding period earlier, you may be eligible to pay long-term capital gains tax when you sell rather than short-term capital gains tax, which is more expensive.
What is the meaning of early exercise option? ›
Early exercise means investing in the Company earlier, on the expectation that the value of the stock will increase in the future. The optionholder risks losing all or part of the investment if the value of the company's common stock decreases.
Should I exercise my options now or wait? ›
Exercising Early
In many cases it can be advantageous to exercise your stock options early (provided you have the cash, and assuming you believe in the company given you accepted a job there). The first benefit of exercising early is that you will likely have zero (or very little) tax liability at the time of exercise.
Why does early assignment happen? ›
Early assignment occurs when the owner of an option contract exercises it before the expiration date. This means that if you're short an options contract (either a call or put), you may be required to fulfill your obligations as the seller of the contract before the expiration date.
What happens if you exercise a call option? ›
If the holder of a put option exercises the contract, they will sell the underlying security at a stated price within a specific timeframe. If the holder of a call option exercises the contract, they will buy the underlying security at a stated price within a specific timeframe.
