Early exercise

In short

A friend of mine once held a call option on a stock for months and then watched it come due worth less than it could have been. If you hold American style options, you can use them at any time before they expire, and that is what early exercise means. Often the contract is worth more alive than dead, so exercising early gives up something you already own. The thing you give up is called time value, which is the extra price a market pays for the chance that the stock keeps moving. You have probably heard talk that a call should be left alone until the end, and I would not treat that as a rule. There are a few narrow moments, around a dividend or deep in the money, where the numbers can lean the other way. Before you act, put your own numbers on paper and compare the two choices side by side.

The whole of it

What it is

I once watched an old farmer decide whether to cut his hay on Tuesday or wait for Friday. Cutting early meant he had his crop in hand, but waiting meant it might grow heavier. Early exercise feels a lot like that choice. An option is a contract that gives you the right to buy or sell a stock at a set price, called the strike price. An American style option lets you use that right on any day up to the expiration date. A European style option can only be used at the end. Many options on single stocks and exchange traded funds are American style, while many index options are European style. Your broker will show you which kind you hold.

You have probably noticed that an option has two parts to its price. The first part is intrinsic value, which is how far the option is in the money right now. A call with a strike of 50 dollars on a stock at 60 dollars has 10 dollars of intrinsic value. The second part is time value, which is whatever the option costs above that. If the same call trades at 12 dollars, the extra 2 dollars is time value. Exercising early collects the 10 dollars and throws away the 2. Selling the option instead would collect all 12.

That small gap is the whole story. Pay attention to it.

How it works

If you are holding a call and you exercise it, you buy 100 shares per contract at the strike price. You pay cash for them, or borrow on margin if your account allows it. If you are holding a put and you exercise it, you sell 100 shares at the strike price and receive cash. The person on the other side, called the writer, gets assigned and must do their part. The Options Clearing Corporation handles that matching, and you can read how assignment works in its own materials.

A call holder should think hard about dividends. When a company pays a dividend, the stock price tends to drop by about that amount on the ex dividend date, which is the first day a buyer no longer gets the payment. An option holder does not receive the dividend. A share owner does. So a deep in the money call that has almost no time value left may be worth exercising the day before the ex dividend date, since the shares would then earn the payout. That only makes sense if the dividend is bigger than the time value you would give up, plus the interest you lose by paying the strike price early.

Puts work a little differently. When you hold a deep in the money put, the cash from selling shares at the strike can earn interest right away. Waiting costs you that interest. So for puts, early exercise can make sense when the option is far in the money and has little time value left. A short seller of a put should expect this and keep cash ready.

The numbers, and where to find yours

Some of the figures that shape this choice are set by law or by your own contract, so I will not guess at them. The standard contract size is 100 shares, and your broker confirms it for each option. Your strike price and expiration date are printed on your position screen. The dividend amount and the ex dividend date come from the company, and many brokers list them on the stock page. Your cost to borrow, if you use margin, is your broker's posted rate.

Taxes matter here too. The Internal Revenue Service sets the holding period needed for a long term capital gain. The cutoff is the current figure, which the official source publishes each year. When you exercise a call, your cost basis in the shares is generally the strike price plus what you paid for the option. The holding period for those shares generally begins the day after you exercise, and it does not count the time you held the option. IRS Publication 550, Investment Income and Expenses, explains how options and stock are treated. Read the section on options before you decide, because the rules differ if you sold the contract rather than exercised it.

Check your own account for three things. Look at the option's current price. Look at the stock's current price. Look at the strike. With those three numbers you can find intrinsic value and time value in about a minute.

A worked example

Let me tell you about a woman named Maria. She bought one call option contract on a stock, with a strike price of 50 dollars. That contract covers 100 shares. The stock now trades at 60 dollars, and the option is priced at 10.80 dollars per share. The company will pay a dividend of 0.60 dollars per share, and the ex dividend date is tomorrow.

First, Maria finds the intrinsic value. The stock price minus the strike is 60 minus 50, which equals 10 dollars per share. The option trades at 10.80, so the time value is 10.80 minus 10.00, which equals 0.80 dollars per share. Across 100 shares, that is 80 dollars of time value.

Second, she looks at the dividend. The dividend is 0.60 dollars per share, so exercising and owning the shares tomorrow would earn her 0.60 times 100, which equals 60 dollars.

Third, she counts what she gives up. She gives up 80 dollars of time value. She also pays 5,000 dollars early for the shares, which is 50 times 100. Suppose she could earn about 4 percent a year on that cash. For the 30 days until the option would have expired, that interest is 5,000 times 0.04 times 30 divided by 365, which equals about 16.44 dollars.

Fourth, she compares. The gain from exercising is 60 dollars of dividend. The cost of exercising is 80 dollars of time value plus 16.44 dollars of interest, which equals 96.44 dollars. The dividend of 60 dollars is less than 96.44 dollars. So exercising early would cost her about 36.44 dollars more than it earns. In this case, selling the option would have kept more money in her pocket.

Now change one thing. Say the option had traded at 10.05 dollars. The time value would then be 0.05 dollars per share, or 5 dollars total. The cost of exercising would be 5 plus 16.44, which is 21.44 dollars. The dividend of 60 dollars would beat it by 38.56 dollars. Same stock, same dividend, different answer. The size of the time value decided it.

Where it goes wrong

I have seen smart people trip over the same few stones. The first is exercising a call because it is deep in the money and feels done. Feeling done is not a number. If time value remains, selling the contract keeps it.

The second is forgetting the cash. A friend of mine once learned that exercising a call means paying the full strike price. A single contract can call for thousands of dollars. If your account does not hold that much, your broker may sell the shares right away or charge you margin interest. Neither is a happy surprise.

The third is missing the deadline. Brokers set their own cutoff times for exercise instructions, and those often come earlier than the market close. Look up your broker's rule. Blown deadlines are a sad way to lose money.

The fourth is the other side of the trade. If you wrote a call or a put, you can be assigned at any time, not just on the last day. A short call can be assigned just before an ex dividend date. Keep that in mind.

The fifth is tax. When you exercise a call, the strike price plus what you paid for the option becomes your cost basis. The holding period on the shares starts fresh. You can mix up your own records if you do not keep notes. Write down the date, the strike, and what you paid for the option.

Questions to answer before you leave this page

Do you know whether your option is American style or European style, and what that lets you do? What is the stock price, the strike price, and the option price today, and what time value is left when you subtract? Is there a dividend coming, and is it bigger than the time value plus the interest on the cash you would pay early? Does your account hold enough cash to buy the shares if you exercise, or would you be borrowing? What is your broker's cutoff time for exercise, and is it before the market closes? If you wrote the option instead of buying it, are you ready to be assigned early? And have you read the options section of IRS Publication 550 to see how your choice affects your taxes?