Early exercise assignment

What Is Early Exercise (Assignment)?

Early exercise, in the context of derivatives, refers to the right of an American-style options holder to exercise their options contract at any point before its expiration date. This stands in contrast to European-style options, which can only be exercised at expiration. For the option writer, early exercise by the holder results in an "assignment," meaning the writer is obligated to fulfill the terms of the contract. This concept is fundamental to options trading and also plays a significant role in equity compensation plans, particularly for employee stock options.

When an option is exercised early, the holder transforms their right to buy (for a call option) or sell (for a put option) shares at a predetermined strike price into an immediate transaction. The decision to early exercise is typically driven by specific market conditions, such as impending dividends for call options or significant movements in the underlying asset's price for put options.

History and Origin

The concept of early exercise is inherently tied to the development of options markets. While options have existed in various forms for centuries, the formalization and widespread trading of standardized options contracts, particularly American-style options, cemented the importance of the early exercise feature. The modern era of options trading began with the establishment of the Chicago Board Options Exchange (CBOE) in 1973. This marked a significant step in standardizing contracts and creating a liquid marketplace.

The ability to early exercise provides a different risk-reward dynamic compared to options that can only be exercised at maturity. Early research into option valuation, such as the Black-Scholes model, initially focused on European options due to their simpler mathematical treatment. However, the unique characteristic of early exercise in American options led to further development in pricing models to account for this valuable right. Empirical studies have since investigated the economic significance of the right of early exercise in option prices.¹¹ Research has also explored how this feature influences expected option returns.¹⁰

Key Takeaways

• Early exercise allows the holder of an American-style option to exercise their contract before its expiration date.
• For the option writer, early exercise leads to an assignment, obligating them to buy or sell the underlying asset.
• This feature is a key differentiator between American-style and European-style options.
• Decisions to early exercise often consider factors such as dividend payments for call options or strategies to lock in profits or limit losses for put options.
• In employee stock options, early exercise can offer potential tax advantages related to the capital gains holding period.

Interpreting Early Exercise

The interpretation of early exercise depends on whether one is the option holder or the option writer.

For an option holder, the decision to early exercise a call option is typically considered when the underlying stock is about to pay a dividend and the option is significantly in-the-money. By exercising the call option and taking ownership of the stock, the holder becomes eligible to receive the dividend. However, exercising early means giving up the remaining time value of the option. For a put option, early exercise may be considered if the underlying stock's price has fallen significantly, allowing the holder to realize profits immediately, especially if concerns exist about the stock recovering or if the holder wishes to deploy capital elsewhere.

For an option writer, an assignment notice indicates that the holder of a short option position has chosen to early exercise. The writer is then obligated to fulfill the contract, meaning they must either sell the underlying shares (for a short call) or buy the underlying shares (for a short put) at the strike price. Option writers need to be aware of the potential for early assignment, particularly for in-the-money American-style options, and manage their risk accordingly.

Hypothetical Example

Consider an employee, Sarah, who received 1,000 non-qualified stock options (NSOs) from her startup employer. The options have a strike price of $1 per share and a four-year vesting schedule. Her company allows for early exercise.

Shortly after receiving the grant, when the fair market value (FMV) of the stock is still $1 per share, Sarah decides to early exercise all 1,000 unvested options. She pays $1,000 ($1 x 1,000 shares) to purchase the shares. Although she owns the shares, they are still subject to the original vesting schedule; if she leaves the company before the shares vest, the company generally has the right to repurchase the unvested shares at her original purchase price.

By early exercising, Sarah immediately starts the clock for long-term capital gains treatment. If the company's value significantly increases over the next few years, and she holds the shares for the required period, any profit from selling the shares above her $1 cost basis would be taxed at potentially lower long-term capital gains rates. If she had waited until her options vested and the stock's FMV had risen to, say, $10, exercising then would trigger ordinary income tax on the $9 "spread" per share, which could be a much higher tax liability.

Practical Applications

Early exercise is a critical feature in several financial contexts:

• Employee Stock Options: Many private companies, especially startups, offer early exercisable incentive stock options (ISOs) and NSOs to employees. This allows employees to purchase shares before they vest, potentially starting the long-term capital gains holding period sooner and minimizing the tax burden on the "spread" between the strike price and the fair market value (FMV) if they file an 83(b) election with the IRS.⁹ The Securities and Exchange Commission (SEC) provides example forms for stock option agreements that include early exercise provisions.⁸
• Dividends and Call Options: Holders of in-the-money American-style call options may choose to early exercise just before an ex-dividend date to capture the upcoming dividend payment. This is a common strategy, as option holders typically do not receive dividends on the underlying stock unless they own the shares.
• Risk Management for Put Options: Investors holding American-style put options might early exercise if the underlying stock price drops significantly below the strike price. This allows them to immediately sell the stock at the higher strike price, locking in profits or mitigating further losses, especially if they believe the stock may rebound.
• Options Clearing Procedures: The process of early exercise and subsequent assignment is governed by rules set by regulatory bodies and clearing corporations like The Options Clearing Corporation (OCC). These rules outline the procedures for submitting exercise notices and the assignment process for option writers.⁷,⁶

Limitations and Criticisms

While early exercise offers potential advantages, particularly in tax planning for employee stock options, it also comes with limitations and risks.

One primary criticism, especially in the context of employee stock options, is the liquidity risk. When an employee early exercises unvested shares, they are paying money upfront for shares that are often illiquid, especially in private companies. If the company's value declines or fails to grow, the investment could become worthless, resulting in a financial loss for the employee.⁵ There is no guarantee that the stock price will appreciate, and employees may realize a loss on their investment if the stock declines after exercise.⁴ Furthermore, even if the shares vest, liquidity constraints in private markets mean employees cannot easily convert their shares to cash until a liquidity event, such as an initial public offering (IPO) or a company sale.³ This ties up an employee's capital and shifts more investment risk to them.²

For market-traded options, the decision to early exercise typically means sacrificing the remaining time value of the option, which can represent a significant portion of the option's premium. For American-style call options on non-dividend-paying stocks, it is generally considered sub-optimal to early exercise because the value of holding the option until expiration (due to its time value) almost always outweighs the benefits of early exercise. The exceptions primarily involve dividend capture or specific arbitrage opportunities. Similarly, for put options, while early exercise can lock in profits, the loss of time value must be weighed against the immediate gain.

Academic research indicates that while the right to early exercise has a measurable economic value, actual exercise behavior by investors is not always optimal, suggesting that investors may not fully incorporate all relevant characteristics into their exercise decisions.¹

Early Exercise vs. European Exercise

The core distinction between early exercise and European exercise lies in the flexibility of when an options contract can be settled.

Early Exercise is a characteristic of American-style options. It grants the option holder the right to exercise their option at any time between the purchase date and the expiration date. This flexibility can be valuable, allowing holders to react to immediate market events, such as impending dividends for a call option or sharp price drops for a put option. However, this flexibility also means the option writer is exposed to the risk of early assignment at any point before expiration.

European Exercise, on the other hand, is a feature of European-style options. With European exercise, the option holder can only exercise their right on the expiration date of the contract, not before. This lack of flexibility means that investors cannot capitalize on mid-contract events by exercising the option. While this might seem like a disadvantage, European options are often simpler to price due to their fixed exercise date, and they typically do not carry the risk of early assignment for the option writer. Despite the restricted exercise window, the option position can still be closed out in the market at any time before expiration.

FAQs

What does "assignment" mean in the context of early exercise?

Assignment refers to the obligation of an option writer (seller) to fulfill the terms of the options contract when the option holder (buyer) chooses to exercise their right. If an American-style call option is exercised early, the writer of that call is "assigned" and must sell the underlying shares at the strike price. If an American-style put option is exercised early, the writer is "assigned" and must buy the underlying shares at the strike price.

Why would someone choose to early exercise a stock option?

Individuals often choose to early exercise stock options, particularly employee stock options, for potential tax benefits. By exercising when the fair market value (FMV) is low (often at the grant date), they can "lock in" a lower taxable amount on the difference between the strike price and FMV. This allows the holding period for long-term capital gains to start sooner, potentially reducing the tax liability when the shares are eventually sold, assuming the company's value increases.

Are all options eligible for early exercise?

No. Only American-style options are eligible for early exercise. European-style options can only be exercised on their expiration date. Most standardized equity options traded on exchanges in the U.S. are American-style. However, many index options are European-style.

What are the risks of early exercise for employees with stock options?

A significant risk for employees who early exercise is that they pay money upfront for shares that are often illiquid and still subject to a vesting schedule. If the company's value declines or fails, the employee could lose their invested capital. Additionally, if the employee leaves the company before the shares fully vest, the company typically has the right to repurchase the unvested shares, often at the original purchase price.