Every option has an expiration date. The option buyer has the right to exercise their option at any time prior to expiration. The option seller is obligated to accept assignment per the option contract’s terms.
An option's early exercise feature is a special provision in the contract that allows the buyer to purchase or sell the underlying asset prior to the expiration date. Early exercise is a unique feature of American-style options and it is not available for European-style options. An American-style option can be exercised at any time before expiration, while a European-style option can only be exercised on its expiration date.
What is Early Exercise?
Early exercise is the process of exercising an option prior to its expiration date. This means the holder of the option will immediately be entitled to their profits, losses or any other benefits associated with owning the underlying asset. Early exercise can be beneficial in certain situations, such as when the stock price rises above a call option’s strike price by more than the premium paid to purchase the option.
How Does Early Exercise Work?
The early exercise process is simple and straightforward. All you need to do is contact your broker with the request.
When you exercise an option, you’re buying (in the case of a call) or selling (in the case of a put) 100 shares of the underlying stock at the strike price. Your broker will then transfer those shares into your account. You must have enough funds in your account to purchase shares or hold a short position. Only certain margin accounts allow you to short sell a stock.
The OCC facilitates the assignment process and randomly assigns the exercised option to an investor that is short the option.
Why (and when) You Should Exercise Options Early
All options have extrinsic value prior to expiration. Typically, investors do not want to exercise an option early because they forfeit the option’s remaining time value. Early exercise is most commonly used with stock call options, specifically options that are deep-in-the-money. An investor can exercise the call option, buy the underlying stock at the option’s strike price, and then either hold it (if they expect the stock to continue to rise), or sell it immediately in the open market at its current market price. By doing this, they have effectively profited from their long call position.
Dividends are often a key factor when deciding to exercise early. If you are holding an American-style call option on a stock that pays dividends, you can exercise the option and acquire shares before the ex-dividend date and collect the payment. By exercising your option prior to expiration, you can take advantage of this extra income stream. However, you’ll still need to consider the underlying stock’s price relative to the option’s strike price, as it may not be advantageous to exercise the option early.