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.

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 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.

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.

RELATED TERMS
  1. Call On A Call

    A type of compound option in which the investor has the right ...
  2. Exercise Price

    The price at which the underlying security can be purchased (call ...
  3. Capped Option

    A capped option limits, or caps, the maximum profit for the holder ...
  4. European Option

    An option that can only be exercised at the end of its life, ...
  5. Statutory Stock Option

    A qualified employee stock option, known as a statutory stock ...
  6. Interest Rate Options

    An interest rate option is a financial derivative allowing the ...
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

    Exploring European Options

    The ability to exercise only on the expiration date is what sets these options apart.
  4. Investing

    Take Advantage of Employee Stock Options

    If your employer offers stock options, they can contribute to your long-term financial success. Here's how.
  5. Trading

    American Vs. European Options

    These two options have many similar characteristics, but it's the differences that are important.
  6. Personal Finance

    Understanding Your Employee Stock Options

    The real value of a stock option lies in the percentage the stock options represent in the company and how quickly they vest.
  7. Trading

    Understanding How Dividends Affect Option Prices

    Learn how the distribution of dividends on stocks impacts the price of call and put options, and understand how the ex-dividend date affects options.
RELATED FAQS
  1. How do I change my strike price once the trade has been placed already?

    Learn how the strike prices for call and put options work, and understand how different types of options can be exercised ... Read Answer >>
  2. Can an option be exercised on the expiration date?

    The use of options has increased dramatically over the years as a way to profit from or hedge against the volatile movements ... Read Answer >>
  3. What is index option trading and how does it work?

    Learn about stock index options, including differences between single stock options and index options, and understand different ... Read Answer >>
  4. How Do Insiders Buy Stock at Below Market Value?

    Stock options allow executives and key employees to buy stock at a price below market value. Read Answer >>
Hot Definitions
  1. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
  2. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its current share price relative ...
  3. Internal Rate of Return - IRR

    Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments.
  4. Limit Order

    An order placed with a brokerage to buy or sell a set number of shares at a specified price or better.
  5. Current Ratio

    The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations.
  6. Return on Investment (ROI)

    Return on Investment (ROI) is a performance measure used to evaluate the efficiency of an investment or compare the efficiency ...
Trading Center