Early exercise

What Is Early Exercise?

Early exercise refers to the act of using the right granted by an American option to buy or sell the underlying asset at the strike price before its official expiration date. This action is specific to American-style option contracts within the broader field of options trading, as European-style options can only be exercised at maturity. The decision to early exercise is typically driven by specific market conditions or events, such as the payment of a dividend by the underlying stock or a significant change in interest rates.

When an option holder chooses to early exercise, they forgo any remaining time value that the option might have. Instead, they immediately realize the option's intrinsic value. This contrasts with holding the option until expiration, where both intrinsic and time value contribute to the option's premium.

History and Origin

The concept of early exercise is intrinsically linked to the evolution of options trading itself, which has roots dating back to ancient times with contracts that offered contingent rights¹⁰, ¹¹. Early forms of options were traded on various bourses in Europe, such as Antwerp in the 16th century and Amsterdam in the 17th century, often with unique terms and conditions⁹. However, these early contracts were largely unregulated and lacked standardization.

A significant turning point for options, and thus for the concept of early exercise in a standardized market, occurred with the establishment of the Chicago Board Options Exchange (CBOE) in 1973⁷, ⁸. The CBOE was the first exchange in the United States to offer standardized, listed options contracts, initially for call options on 16 underlying stocks⁶. This standardization included defining clear strike prices and expiration dates, which formalized the window during which an American option could be exercised prior to its maturity. Prior to this, options were primarily traded in an over-the-counter (OTC) market, often with complex and variable terms⁵. The development of organized exchanges and central clearinghouses like the Options Clearing Corporation (OCC) provided the infrastructure for consistent exercise procedures and the clear distinction between American and European-style options.

Key Takeaways

• Early exercise allows the holder of an American-style option to exercise their right to buy or sell the underlying asset before the contract's expiration date.
• This action is primarily relevant for American options; European options can only be exercised at expiration.
• The decision to early exercise involves weighing the immediate realization of intrinsic value against the loss of the option's remaining time value.
• Key factors influencing an early exercise decision often include dividend payments for call options and high interest rates for put options.
• Suboptimal early exercise can occur when an option holder exercises their option even when it is not financially advantageous to do so.

Interpreting the Early Exercise

The decision to early exercise an option is a complex one, primarily influenced by the type of option (call option or put option) and specific market factors.

For call options, early exercise is generally considered only when the underlying stock is about to pay a substantial dividend. If the dividend amount is large enough to offset the remaining time value of the option, an option holder might exercise to receive the dividend payment. Otherwise, holding a call option rarely benefits from early exercise because doing so sacrifices any extrinsic value without a compensating factor like a dividend.

For put options, early exercise can be beneficial, particularly when the option is deep in-the-money and interest rates are high. Exercising a put option early allows the holder to sell the underlying asset, receive cash, and then invest that cash at the prevailing interest rate. This potential interest income can, in some scenarios, outweigh the remaining time value of the option. Academic research indicates that American put options on dividend-paying stocks are most likely to be exercised either just after an ex-dividend date or just prior to expiration⁴.

Hypothetical Example

Consider an investor, Sarah, who holds an American-style call option for XYZ Corp. with a strike price of $50 and an expiration date three months away. The current market price of XYZ Corp. stock is $55. The option currently has an intrinsic value of $5 ($55 - $50).

XYZ Corp. announces a special cash dividend of $1.50 per share, with an ex-dividend date next week. Sarah realizes that if she exercises her call option before the ex-dividend date, she will become a shareholder and be entitled to receive the $1.50 dividend per share. However, if she waits, the stock price is likely to drop by approximately the dividend amount on the ex-dividend date, and she would miss out on the dividend payment while still holding the option.

Sarah calculates that the remaining time value of her option is $1.00. By exercising early, she gains the $1.50 dividend but loses the $1.00 of time value. In this specific scenario, the net gain from early exercise would be $0.50 ($1.50 dividend - $1.00 time value). Therefore, Sarah decides to early exercise her option contract to capture the dividend payment.

Practical Applications

Early exercise is a critical consideration for participants in the options trading market, impacting strategies from speculative trading to hedging. Understanding when and why to early exercise is essential for maximizing profits or minimizing losses.

One practical application involves arbitrage strategies. For instance, if an American call option is priced significantly below its intrinsic value plus the present value of future dividends, an arbitrageur might consider purchasing the option, immediately exercising it, receiving the underlying shares, and then potentially selling those shares for a profit or holding them to collect dividends. This action exploits pricing inefficiencies.

Furthermore, investors holding short positions in options (i.e., option writers) must be aware of the risk of being assigned an early exercise notice. This can occur, for example, if they have written a call option on a stock that is about to go ex-dividend, and the option holder decides to early exercise to capture the dividend. Regulations set by bodies such as the Securities and Exchange Commission (SEC) govern the conduct and procedures related to options trading, including exercise and assignment protocols³.

Limitations and Criticisms

Despite its potential advantages in specific scenarios, early exercise is often considered a suboptimal decision from a purely financial perspective for many American options. The primary criticism stems from the fact that early exercise always results in the forfeiture of any remaining time value embedded in the option's premium. For most of an option's life, especially when there is still significant time until the expiration date, this time value contributes to the option's total worth beyond its intrinsic value.

Academic research has even explored instances of investor suboptimal non-exercise of American call options, suggesting that a significant portion of potential gains can be lost when investors fail to make the optimal exercise decision¹, ². This "opportunity cost" can be substantial, as the value gained from early exercise (e.g., a dividend) may not fully compensate for the lost time value, especially when factoring in transaction costs associated with exercising the option and potentially trading the underlying asset. Therefore, the decision to early exercise requires careful analysis to ensure it truly offers a financial advantage over holding the option or selling it in the market.

Early Exercise vs. European Option

The fundamental distinction between early exercise and a European option lies in the flexibility of when the option can be exercised.

Early Exercise is the act of triggering the rights of an American option at any point between its purchase and its expiration date. This flexibility is a key characteristic of American options, allowing the holder to take advantage of specific market events, such as dividend payments for calls or interest rate advantages for puts, that might make immediate exercise beneficial.

In contrast, a European option can only be exercised on its expiration date. There is no possibility of early exercise for a European option, regardless of how favorable market conditions might become prior to maturity. This restriction simplifies the pricing models for European options compared to their American counterparts. The difference in exercise flexibility is often reflected in the option's premium, with American options typically commanding a slightly higher price due to the added right of early exercise.

FAQs

When should you consider early exercise of a call option?

You should primarily consider early exercise of an American call option when the underlying stock is about to pay a substantial dividend, and the value of that dividend outweighs the option's remaining time value and any associated transaction costs.

Is early exercise always a good idea for American options?

No, early exercise is not always a good idea. In most cases, exercising an American option early means forfeiting its remaining time value, which can lead to a less profitable outcome than selling the option in the market or holding it until expiration date. The decision depends on a careful analysis of the specific circumstances.

What is the main difference between American and European options regarding exercise?

The main difference is that American options allow for early exercise at any time before expiration, while European options can only be exercised on their expiration date.

Does early exercise apply to put options?

Yes, early exercise also applies to American put options. It can be advantageous for put options, particularly when the option is deep in-the-money and there is a significant benefit to receiving the cash from selling the underlying asset and investing it at high interest rates.