Options are a fantastic tool for trading and investing.
They offer freedom and flexibility in timing, strategy, risk, and profit-taking and have become one of the most used trading instruments in the markets.
One misunderstood concept about options is how often they get exercised early.
The answer is less often than you would think.
Below, we will go over what early exercise is, what options it affects, and how it could affect you as a trader.
Contents
A Quick Review of Options Basics
Before jumping into the weeds about early expiration, let’s recap some basic options, terms, and concepts.
First are two types of options contracts: Calls and Puts.
Calls are the right, but not the obligation, to purchase the underlying at the strike price by the expiration date.
A put is the right, but not the obligation, to sell the underlying at the strike price by the expiration.
It should also be noted that if your option is $0.01 In the Money or more in the US, it will be auto-exercised at expiration.
Next are the two different types of options contracts: American and European.
The differences between these two contract types can be complicated.
Still, for our purposes, we can break it down to American options, which can be voluntarily exercised at any time up to expiration, and European options, which can only be exercised at expiration.
Exercised Vs. Assigned
One additional component of options that we need to be aware of is the difference between when an option is exercised vs when it is assigned.
Exercised – Only a long option can be exercised, and this is the voluntary exchange by the contract owner to pay for the underlying shares at the specified strike. As we examined above, early exercise is only possible in American-style options.
Assigned – Only a short-option contract can get assigned. The contract seller has no say in whether their contract gets assigned to them; it is strictly at the will of the option buyer (the other side of the trade); this is where the risk of early exercise sits with the option seller.
Given what we now know about Exercised vs Assigned options, it should make sense why Cash Secured Puts take the entire amount of the underlying as collateral and why short calls often require you to have the 100 shares of stock as collateral for the trade (covered call).
Trading Scenarios
Now that all of the basics are covered let’s look at some examples of options trades and see if it would make sense to exercise them early.
Example 1:
A trader buys 5 AMD $100 call options that expire in 90 days, and AMD is currently trading at $97/share.
The trader spends $5/contract on the trade. In the next ten trading days, AMD rallies up to $105/share, making that trader’s contracts worth $11 each.
Would it make sense for them to exercise the contracts and take control of the shares?
If you said no, you are correct.
If the trader exercised the contracts, they would pay $100/share for the stock, immediately grossing the buyer a $5/share profit but netting them $0 after the cost of the option is figured in.
Were they to sell the options instead, they would net a $6/share profit and would not be required to outlay all of the capital to buy the stock.
This is because, on top of the $5/share of intrinsic value the option has, there is still so much time left that it also has $6 of extrinsic value.
Example 2:
A trader buys 1 AMZN $75 call contract that expires in 45 days while AMZN trades at $75/share (so they are at the money).
The trader pays $4 for the call.
Over the next seven trading days, the stock trades up to $85/share, and the call is now at $11. Should the trader exercise their call?
This time is a bit trickier given that it’s significantly more in the money, but the answer here would probably be no.
If the trader sells the option at a profit, they would net $7/contract before fees. If they were to exercise the contract and then immediately sell the shares, they would get $6/share in profit, $85 selling price – $75 cost of the shares – $4 cost of the option = $6 net profit per share.
Additionally, the trader would have to outlay $7,500 in margin or cash to purchase the shares, dramatically reducing the return on capital.
When To Exercise Early?
Given that most traders would rather close the option and realize the larger percentage gain on the option, what are a few reasons that an option would be exercised early?
First, suppose there is a special announcement on the stock.
In that case, If the company announces a special distribution or dividend with the ex-date before your expiration date, exercising and taking possession of the shares may make sense.
This is especially true if you still maintain your theory that the stock is going up (assuming it was a call option).
You want to capitalize on both the dividend and the appreciation.
The second reason would be the announcement of a stock split that falls inside your holding period.
While technically, the options adjust to the new share count, if you are holding through a split, it is often easier to exercise and sell the shares post-split if your account can handle that.
The third and final reason would be that a held call is deep in-the-money, and there is very little time left until expiration.
This would allow the exerciser to forfeit very little extrinsic value on the option and take possession of the shares at a steep discount.
This, however, is also pretty rare unless the option holder is a long-term investor or sees a lot of potential upside left on the stock and does not want to spend additional capital for another deep-in-the-money call.
Calls Vs. Puts
Another thing to notice is that all of the above examples have long calls and no puts.
The reason for this is in how the contracts operate.
A long call lets the trader purchase the stock, whereas a long put lets the trader sell it.
That is not to say long puts cannot be exercised early; it’s just a much more specific scenario that it would happen.
There is only one common reason to exercise a put early: to protect an underlying position.
If you are long 100 shares of stock and purchase an at-the-money put for protection, often closing the put for a profit makes sense if the price falls.
The exception to this rule is if the company comes out and announces news of either a bankruptcy or some other event that would materially change the company.
If this happened and the stock was to plunge with little immediate chance of rebounding, exercising the put and selling your shares would make sense.
This would allow you to exit the position, and the only real cost associated with it is the purchase price of the put.
Conclusion
Many long and short options traders are concerned with early expiration when they are in a trade, but after looking at why a trader might exercise early, it would appear to be an exceedingly rare event.
Unless a special announcement is made that the trader would benefit from holding the actual shares or the contracts that are held are deep in the money with little time left, selling to close the option often makes the most sense.
This is not to say it is not a risk. It is just not as large a risk as many traders think.
We hope you enjoyed this article on options early exercise.
If you have any questions, please send an email or leave a comment below.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
