What Is Early Exercise?
Early exercise in trading refers to exercising an options contract before its expiration date. Thus, deciding to exercise an option early depends on the individual’s investment strategy. Hence, this aims to capture dividends, exploit arbitrage opportunities, and manage risk and liquidity needs.
It provides traders with flexibility in managing their options positions. It allows them to customize their trading approach based on market analysis and risk-reward preferences. Therefore, traders can exercise options early to align with their goals and objectives. However, this decision to exercise early should consider factors such as transaction costs, taxes, and overall risk-reward.
Table of contents
- Early exercise, in options trading, means using one’s right to act on an option before it expires.
- The decision to exercise early depends on various factors, like the market conditions, the option’s value, and the trader’s goals.
- Moreover, this practice is typically applied to stock options or equity-based indices. Hence, option holders should follow such rules to capitalize on price movements, earn dividends, and risk management.
- These practices help lock in profits, capture dividends, strategic positioning, and better tax planning.
Early Exercise Explained
Early exercise is specific to American option contracts, allowing the holder to exercise any time before expiration. European option contracts, on the other hand, are accessible only on the day they come to an end, making early exercise impossible.
In practice, most options traders do not typically use early exercise for their options. Instead, they tend to close their positions by selling the options in the market. By selling the options, traders aim to profit from the difference between the selling price and the original purchase price of the options. Hence, this profit is generated through changes in the options’ market value, influenced by factors such as the underlying asset‘s price movements, volatility, time decay, and other market conditions.
Therefore, closing the trade by selling the options provides traders more flexibility and liquidity, as they can capture profits without directly acquiring or selling the underlying asset. Additionally, selling the options allows traders to benefit from any remaining time value in the options, which can be advantageous if there is still a significant period until expiration.
Hence, it is vital to note that this practice is only sometimes beneficial. Thus, the value of an option consists of intrinsic value and time value. Thereby, by exercising early, the option holder forfeits the remaining time value. Moreover, deciding to exercise a stock option early depends on several factors, including the type of option, the current market price of the underlying stock, the investment objective, and specific terms of the option contract. Furthermore, some common tax implication of early exercise includes:
- Ordinary Income tax
- Alternative Minimum Tax
- Holding Period And Capital Gains Tax
- Employment Tax
- State and Local Taxes
Let us understand the concept better with the help of an example.
Let’s assume John holds a put option on XYZ Company stock with a strike price of $100 and an expiration date in two weeks. The current market price of XYZ stock is $90, and the option is currently in the money.
Specific market indicators and news suggest a sharp decline in XYZ stock, so John decides to exercise the put option early to protect against potential losses.
Hence, by exercising the put option early, John demands the options seller to buy shares of XYZ stock from him at the strike price of $100. Since the current market price is lower at $90, John can effectively sell the shares higher than the current market price.
Therefore, after exercising the put option early, John receives the strike price of $100 per share from the options seller and delivers the XYZ shares. As a result, John locks in a profit of $10 per share ($100 selling price – $90 market price) for the claims he holds.
The early exercise allowed John to protect himself from a potential stock price decline in this hypothetical scenario. In addition, by exercising the put option and selling the shares at a higher strike price, John could mitigate potential losses that could have occurred if he had waited until expiration.
On March 30, 2023, Aldebaran Resources Inc. disclosed that its most significant shareholder, Route One Investment Company LLC, has agreed to an early exercise of 4.7 MM common share purchase warrants These warrants will expire on May 3, 2023, and have a strike price of $0.70 will generate $3.3 million in gross proceeds for the company.
Following the early exercise stated above, an additional 5.3 million warrants will remain outstanding. The company also reports obtaining an additional drill rig, which will arrive on-site within the next few days.
Aldebaran CEO John Black stated the company appreciates the continued support shown by their largest shareholder, Route One. These warrant exercises help replenish the treasury as we move a fourth drill rig onto the property.
Some potential benefits of early exercise are as follows:
- Dividend Capture: Early exercise can allow option holders to capture dividends paid by the underlying stock. By exercising a call option before the ex-dividend date, the trader becomes the shareholder and is entitled to receive the dividend payment.
- Risk Mitigation: These practices can be used as a risk management strategy to mitigate potential losses. If a trader holds a deep-in-the-money put option, exercising options early allows them to sell the underlying asset at the strike price and limit further downside risk.
- Capitalizing on Market Opportunities: It enables traders to exploit specific market opportunities. For instance, if a sudden favorable price movement or news event significantly affects the underlying asset, exercising options early can allow the trader to secure profits or minimize potential losses.
- Liquidity and Flexibility: By early exercise, traders can convert their options contracts into the underlying asset, which provides more liquidity and flexibility. They can hold, sell, or use the acquired shares for further trading or investment strategies.
- Tax Considerations: In some jurisdictions, exercising an option may result in favorable tax treatment than closing the position by selling the option. However, traders should consult with tax professionals to understand the tax implications of early exercise in their jurisdictions.
The potential risks associated with this practice are as follows:
- Loss of Time Value: By exercising an option early, traders forfeit any remaining time value embedded in the option. Time value represents the premium paid for the potential future price movements of the underlying asset. If there is still time until expiration, exercising the options early may result in leaving potential value.
- Opportunity Cost: They lock in the position and prevent the trader from benefiting from any further favorable price movements in the option or the underlying asset. Hence, if the option still has time remaining and the underlying asset continues to move in a clear direction, the trader may miss out on additional potential profits.
- Increased Transaction Costs: These typically involve additional transaction costs, including fees associated with exercising the option and potential taxes on the acquired shares. Therefore, these costs can erode potential profits and should be considered when exercising early.
- Risk of Adverse Price Movements: While this practice can mitigate risk, it also can expose the trader to adverse price movements. If the underlying asset’s price moves unfavorably after early exercise, the trader may experience losses on the acquired shares.
- Uncertainty and Market Volatility: Market conditions and volatility can significantly impact the outcome of early exercise. Sudden changes in the underlying asset’s price, volatility, or market sentiment can make the timing of early exercise challenging, potentially resulting in suboptimal outcomes.
Frequently Asked Questions (FAQs)
If the underlying stock pays a significant dividend and the dividend amount exceeds the time value remaining in the option, early exercise may be beneficial. By exercising a call option before the ex-dividend date, traders can capture the dividend payment.
For example, this practice is generally not recommended if the option still has significant time value, the underlying asset’s price is expected to move favorably, or other investment opportunities offer better risk-adjusted returns. Additionally, this may not be advisable if the cost outweighs the potential benefits.
The ability to early exercise depends on the type of options contract, the trading platform, and the specific brokerage account. However, some brokerage firms may have restrictions or requirements regarding this practice.
In some cases, it can be done automatically by the brokerage or clearing firm if the option is- in the money by a certain threshold at or near expiration.
This article has been a guide to what is Early Exercise of Options. Here, we explain the topic in detail with its examples, benefits, and risks in options trading. You may also find some useful articles here –