Understanding Early Exercise in Options

05/15/2015 8:00 am EST

Focus: OPTIONS

Knowing when options are likely to be called away early can help traders during the trade selection and management processes, explains Mike Scanlin of BornToSell.com

Early exercise for a call option is when an option holder exercises their purchase right prior to the option's expiration date. Normally an option holder would not do this; they would just wait until expiration day and then decide if they want to exercise or not. However, there are some cases when taking early exercise is the optimal decision.

The Call Option Buyer's Rights

Buying a call option means the purchaser has the right, but not the obligation, to buy 100 shares of stock at the strike price any time between that day and when the option expires. The buyer does not need to give a reason for exercising the option; they just inform the broker they'd like to do so.

The Call Option Seller's Obligations

When the options clearing corp. receives an exercise notice from the option holder's broker, they randomly assign the notice among all of the people who have short contracts outstanding (that's why some people may be assigned and others may not be: the assignment is random). If the option seller is given an assignment notice, then they are obligated to deliver the shares in exchange for cash equal to the strike price per share.

Reasons for Early Exercise

The most common reason for early exercise is when the underlying stock is about to pay a dividend. Call option holders do not receive dividends, but stockholders do. In addition, the day the stock goes ex-dividend, the underlying stock price will be reduced by the amount of the dividend, thus reducing the value of the call option. Some call option holders will exercise the day before the ex-dividend date in order to get the dividend as a result.

The downside of early exercise for the option holder is that they forfeit any time premium remaining in the option. If they want out of their long call option position while it still has time premium, they are better off just selling their option instead of exercising it.

Does Early Exercise Matter for Covered Call Investors?

Normally, having stock called away is a result covered call investors look forward to. It means they have achieved the best possible outcome. To get this result sooner than the expiration day is considered a good thing.

The only time an investor may not want early exercise has to do with taxes. Having your shares called away is the same (for tax purposes) as selling your shares. That sale could generate an unwanted tax event (a realized gain or realized loss) if the shares are held in a taxable account.

Early exercise in a non-taxable account, like an IRA, is no big deal. If the investor still wants to own the shares, they can just go buy replacement shares.

2 Ways to Protect Against Early Exercise

First of all, the option you sold has to be in the money. It would be silly for the holder to take early exercise on any option that wasn't in the money.

Second, if you don't want your shares called away, a couple of days before each ex-dividend date, you should check the amount of time premium remaining in the option you've sold. If an in-the-money option has only a few pennies (or less) of time premium, you may want to buy those options back and sell new ones that have more time premium since most rational investors will not opt for early exercise if there is still a decent amount of time premium left in the option.

What About Stocks That Don't Pay Dividends?

It is very unlikely (read: it would be irrational) that an option holder would take early exercise on a non-dividend-paying stock. Again, they will forfeit any remaining time premium, so they would be better off just selling their call option instead of exercising it.

By Mike Scanlin of BornToSell.com

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