Early Exercise (Options)

Definition

The term early exercise refers to a feature of American options that permit the holder to exercise the option prior to its expiration date.  While most index options are of the European-style, options involving equities are typically of the American-style.

Explanation

While European options can only be exercised on their expiration date, American-style options allow holders to exercise the option prior to its expiration date. Early exercise of a call option allows the holder to purchase the underlying asset, or stock, at the strike price prior to expiration.  Early exercise of a put option allows the holder to sell the underlying asset, or stock, at the strike price prior to expiration.

The total value of an option includes both an intrinsic as well as extrinsic component.  The extrinsic value of an option is equal to its moneyness, while the intrinsic value of an option is a function of the volatility of the underlying asset and the option's time to expiration.  When an option is exercised early, the investor is giving up the intrinsic value of the option.  For this reason, and under most circumstances, it's not advisable to exercise an option early.  However, under certain conditions the early exercise of an option may be advantageous:

  • Interest Income:  when interest rates are sufficiently high, a holder of a put option may be better off exercising their right to sell the stock at the strike price prior to the option's expiration date and allow the cash from the transaction to generate additional interest income.
  • Capture Dividends:  since the holder of a stock on the ex-dividend date is entitled to receive the cash dividend, the holder of an in-the-money call option may be better off exercising their right to purchase the stock prior to the option's expiration date and capture the dividend.

Related Terms

equivalent strategy, equity option, diagonal spread, derivative