The 2 Rules to Early Exercise American Call and Put Options

When is the best time to early exercise call and put options?

I am pretty sure you keep wondering this question as I used to. This article is focused on two basic rules that can address traders in understanding if and when exercising American options early may be the best choice.

Exercising stock options is the action undertaken by the options holder to require the immediate execution of the financial transaction indicated by the contract previously underwritten. This action entails the end of the contract between the two subscribers.

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The options’ exercise is strictly related to the definition of options. Basically, on the market there are two types of options:

1. Call options are contracts that give the owner the right and not the obligation to buy 100 shares of the underlying stock for a fixed price and within a certain time called expiration date.

2. Put options are contracts that give the owner the right and not the obligation to sell 100 shares of the underlying stock for a fixed price and within a certain time called expiration date.

When exercising a call option, the owner requires purchasing the underlying financial instrument from the seller in the quantity and at the strike price specified in the contract. The option seller is obliged to honor the contract by selling to the option holder the underlying at a predetermined strike price.

When exercising a put option, the owner requires selling the underlying financial instrument to the option seller in the quantity and at the strike price specified in the contract. Once again, the seller is obliged to honor the contract by purchasing from the option holder the underlying at a predetermined strike price.

In both cases, when the option owner requires exercising its contracts, the option seller is subject to the so called assignment.

The circumstances under which the option owner may exercise its contracts depend on the option style. There are two different styles of options:

• American style options give the owner the right to exercise the stock options purchased at any time within the options expiration. As a result, these contracts may be subject to early exercise.

• European style options give the owner the right to exercise the stock options purchased only at the expiration date. Conversely, these contracts do not allow early exercise.

When as an options owner you are interested in buying or selling the underlying shares, you must submit exercise instructions to your broker. For instance, imagine the underlying XYZ is trading at $30 and you own a XYZ $25 call in-the-money. By exercising the option, you will give an order to the broker to buy 100 shares of XYZ paying $25 for share and locking in $5 profit per share.

On the other side, imagine that with the underlying trading at $30, you decide to exercise a $35 put option in-the-money. Your brokerage firm will get the order to sell on your behalf 100 shares of XYZ at $35 per share allowing you to pocket $500 profit.

On the US stock market, equity options are of the American style allowing you to exercise them at any time up to the options’ expiration. As options usually expire the third Friday of the expiration month, it would make sense and may seem in your interest to exercise options before the expiration date, but there are fundamental points to take into consideration before exercising an option.

First of all, options should be exercised only if they are in-the-money by a considerable amount that allows the option holder at least to cover the fees due to the broker for the exercise transaction.

Secondly, you should be aware of the fact that options carry within them extrinsic value. By selling your contracts before expiration, you would give up on the part of options’ premium made up mainly of time value for which you have paid before. Consequently, from an economical point of view it may be not convenient exercising options before expiration.

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Early Exercise American Call Options

Besides the above general considerations, for the specific case of call options the decision to perform an early exercise depends on whether or not the stock is about to pay a dividend.

General rule n.1: it is never worth exercising call options early if the stock pays no dividends.

If you take a look at a long call risk profile (chart n. 1) on any trading software, you should notice that you have unlimited profit potential if the stock price rises, but limited losses if the price falls.

Now if you exercise your call early you give up your call option to take delivery of the stock. That means that you lose the limited downside protection. As a result, the risk profile changes dramatically because you will be exposed to unlimited losses if the stock price should fall (chart n. 2 related to a long stock risk profile).

The early exercise of a call option is never recommended if dividends are not involved. There are three main disadvantages you may face by early exercising call options:

1. Premium loss. By exercising options before expiration, you gives away time value;

2. Opportunity cost. As you pay for the stock earlier than necessary, you risk to lose part of the interest could be earned on your money;

3. Possibility to get big losses if the stock price dropped as your downside risk is potentially unlimited.

On the other hand, if the stock is about to pay dividends it might pay to exercise American style call options early. But even for this case you should still wait as long as possible and exercise the day before the dividend is paid.

General rule n.2: it is worth exercising a call option early to collect a dividend only if this dividend is greater than the cost to acquire the stock.

In order to determine if there is a real advantage in performing an early exercise of call options to collect a dividend, you must compare the risk graphs of the two possibilities and try to keep this risk at the same level.

When you exercise a call option and take delivery of the stock you find that your profit/loss graph looks like a straight line. In order to keep the risk profile the same as the long call, you will need to purchase a put option at the same strike. In this way you will limit again your downside risk.

A word of caution: you are always allowed to exercise call options at the expiration day and take delivery of the stock at the same strike price. So be patient and do not exercise call options too early if it is not the best solution from an economical point of view.

Early Exercise American Put Options

All the disadvantages of exercising a call option early become the advantages of exercising a put option. In fact, exercising puts you sell the risky stock and receive back the safe cash. This transaction is perfectly the opposite of what happens when a call option is exercised.

General rule n.1: it is worth exercising a put option early if the interest you receive today is greater than the put time value.

Imagine you purchase today 100 shares of XYZ at $105 plus a 6 month $100 put option. Let us suppose that three months later the stock is traded at $80 (There has been a decreasing in value of $25) and you believe that it will not rise above the $100 strike before expiration (3 months more).

So you have two choices here: 1) You may wait until expiration, exercise it and collect your $100 strike at that time; 2) You may also choose to collect your $100 today exercising your put option early which will earn interest for three months (the time between today and the expiration date).

General rule n.2: exercising put options early may make financial sense only for those times when the stoke price is sufficiently below the strike price.