Early Exercise

Early exercise means using an American style option before its expiration date. It sounds attractive: if a call is in the money, why not take the shares now? In most cases, though, exercising early is a mistake, because it throws away the option's remaining time value. There are two well known exceptions: calls just before a stock pays a dividend and deep in the money puts when interest rates are meaningful. This lesson explains the logic and the numbers.

Why early exercise usually loses#

An option's premium equals its intrinsic value plus extrinsic value. Exercising gives you only the intrinsic value. Selling the option gives you both. See Intrinsic and Extrinsic Value.

There is a second reason to hold a call: it protects you on the downside. If you exercise and the stock then falls sharply, you bear the full loss; if you had kept the call, your loss would be limited to its value.

A classic result, from Robert Merton's work in 1973, is that it is never optimal to exercise an American call early on a stock that pays no dividends. Its price therefore equals the European call price.

Exception 1: calls before a dividend#

When a stock goes ex dividend, its price typically drops by about the dividend amount. Call holders do not receive the dividend; shareholders do. If the dividend is larger than the call's remaining time value, exercising the day before the ex dividend date can be worth it.

consider exercising if dividend > call's extrinsic value (roughly, ignoring interest)

This is why sellers of in the money calls face higher assignment risk before ex dividend dates. See Exercise and Assignment and Dividends.

Exception 2: deep in the money puts#

Exercising a put gives you the strike price in cash now. If the put is deep in the money, its time value is small, and the interest you could earn on the strike between now and expiry may be worth more than the remaining time value.

Early exercise and pricing#

Because early exercise can be valuable, American options are worth at least as much as European options, and sometimes more. Pricing them requires checking at every point whether exercising beats holding, which is why binomial trees and other numerical methods are used. See American Option Pricing and Binomial and Trinomial Trees.

Other situations people exercise early#

• Illiquid options with very wide spreads, where selling would get a poor price. Even then, compare carefully.
• Hard to borrow stocks, where some traders exercise puts to deliver shares they cannot borrow cheaply.
• Tax or account reasons, which should be checked with a professional.

Practical rules#

1. Default to selling rather than exercising.
2. Check dividends if you hold in the money calls, and decide before the ex dividend date.
3. Short call sellers should expect assignment when the dividend exceeds the call's time value.
4. Compare the bid price with intrinsic value before exercising; if the bid is below intrinsic value, exercising may be better.

Frequently asked questions#

Should I exercise my option early?#

Usually not. Selling the option captures both intrinsic and time value, while exercising gives only intrinsic value.

When does early exercise make sense?#

Mainly for calls just before an ex dividend date when the dividend exceeds the remaining time value, and for deep in the money puts when interest on the strike outweighs time value.

Can European options be exercised early?#

No. European options can only be exercised at expiration.

Next, learn the relationship that ties calls and puts together in Put-Call Parity.