What is a 'Early Exercise'

Early exercise of an options contract is the process of buying or selling shares of stock under the terms of that option contract before its expiration date. For call options, the options holder can demand that the options seller sell shares of the underlying stock at the strike price. For put options, it is the converse, where the options holder may demand that the options seller buy shares of the underlying stock at the strike price.

BREAKING DOWN 'Early Exercise'

Early exercise is only possible with American-style option contracts, which the holder may exercise at any time up to expiration. With European-style option contracts, the holder may only exercise on the expiration date, making early exercise impossible.

Most traders do not use early exercise for options they hold. Traders will take profits by selling their options and closing the trade. Their goal is to realize a profit from the difference between the selling price and their original option purchase price. For a long call or put the owner, closes a trade by selling, rather than exercising the option. This trade often results in more profit due to the amount of the time value remaining in the long option lifespan. The more time there is before expiration, the greater the time value is that remains in the option. Exercising that option results in an automatic loss of that time value.

There are certain circumstances under which early exercise may be advantageous for a trader. For example, a trader may choose to exercise a call option that is deeply in-the-money with a relatively near expiration.  Because the option is in-the-money, it will typically have negligible time value. Another reason for early exercise may be a pending ex-dividend date of the underlying stock. Since options holders are not entitled to either regular or special dividends paid by the underlying company, this will enable the investor to capture that dividend. It should more than offset the marginal time value lost due to an early exercise.

Employee Options

There is another type of early exercise that pertains to company awarded stock options (ESO) given to employees. If the particular plan allows, employees, may exercise their awarded stock options before they become fully vested employees. A person may choose this option to obtain a more favorable tax treatment. However, the employee will have to foot the cost to buy shares before taking full vested ownership. Also, any purchased shares must still follow the vesting schedule of the company's plan.

The money outlay of early exercise within a company plan is the same as waiting until after vesting, ignoring the time value of money. However, since the payment is shifted to the present, it may be possible to avoid short-term taxation and the alternative minimum tax (AMT). Of course, it does introduce the risk that the company may not be around when the shares are fully vested.

RELATED TERMS
  1. American Option

    An option that can be exercised anytime during its life. American ...
  2. Call Over

    When the buyer of a call option exercises the option. In options ...
  3. Exercise

    To put into effect the right specified in a contract. In options ...
  4. Employee Stock Option - ESO

    A stock option granted to specified employees of a company. ESOs ...
  5. Aggregate Exercise Price

    The strike price of a put or call option multiplied by its contract ...
  6. Bermuda Option

    A type of exotic option that can be exercised only on predetermined ...
Related Articles
  1. Trading

    Dividends, Interest Rates and Their Effect on Stock Options

    Learn how analyzing dividends and interest rates is crucial to knowing when to exercise early.
  2. Financial Advisor

    The Best Strategies to Manage Your Stock Options

    We look at strategies to help manage taxes and the exercise of incentive and non-qualified stock options.
  3. Trading

    4 Reasons To Hold Onto An Option

    There are times when an investor shouldn't exercise an option. Find out when to hold and when to fold.
  4. Managing Wealth

    Get The Most Out Of Employee Stock Options

    Stock options can be lucrative for employees who know how to avoid unnecessary taxes.
  5. Trading

    Getting Acquainted With Options Trading

    Learn about trading stock options, including some basic options trading terminology.
  6. Trading

    American Vs. European Options

    These two options have many similar characteristics, but it's the differences that are important.
  7. Trading

    Three Ways to Profit Using Call Options

    A brief overview of how to provide from using call options in your portfolio.
RELATED FAQS
  1. After exercising a put option, can I still hold my option contract in order to sell ...

    Once a put option contract has been exercised, that contract does not exist anymore. A put option grants you the right to ... Read Answer >>
  2. When holding an option through expiration date, are you automatically paid any profits, ...

    Holding an option through the expiration date without selling does not automatically guarantee you profits, but it might ... Read Answer >>
Hot Definitions
  1. Return on Assets - ROA

    Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets.
  2. Fibonacci Retracement

    A term used in technical analysis that refers to areas of support (price stops going lower) or resistance (price stops going ...
  3. Ethereum

    Ethereum is a decentralized software platform that enables SmartContracts and Distributed Applications (ĐApps) to be built ...
  4. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  5. Financial Industry Regulatory Authority - FINRA

    A regulatory body created after the merger of the National Association of Securities Dealers and the New York Stock Exchange's ...
  6. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by companies seeking the capital to expand ...
Trading Center