What is 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.

Understanding 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 time value remaining in the long option lifespan. The more time there is before expiration, the greater the time value that remains in the option. Exercising that option results in an automatic loss of that time value.

Key Takeaways

  • Early exercise refers to buying or selling stock shares before the expiration of contract options.
  • It is only possible with American-style options.
  • Early exercise makes sense when an option is close to its strike price and close to expiration. Employees of startups and companies can also choose to exercise their options early to avoid the alternative minimum tax.

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 and is 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 the 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.

Example of Early Exercise

Suppose an employee is awarded 10,000 options to buy company ABC's stock price at $10 per share. They vest after two years. She exercises 5,000 of those options to purchase ABC's stock, which is valued at $15, after a year. Exercising those options will cost her $7,000 based on a federal AMT rate of 28%. However, she can reduce her federal tax percentage to 15% (based on 2019 rates) by holding onto the exercised options for another year to meet requirements for long term capital gains tax.