Early Exercise

Early exercise usually refers to the early carrying out of an options contract. This is an action of purchasing or selling shares according to the stated in the contract conditions before the contract’s expiration date. Options seller may be requested by the options holder to sell his or her shares of the underlying stock at the set price, which is also known as a strike price. The previous sentence describes a contract, which is called a “call option”. The reverse contract is called a “put option” and in this case the option seller is requested by the options holder to buy shares at the set or most commonly known strike price.

Exercising an option

The only option contracts that can be early exercised are American-style options as these kinds of contracts may be exercised by their holders at any time. The situation with European-style option contracts is different, they cannot be exercised at any time, the only possible way to exercise them is to wait until the expiration date comes.

However, not all traders are eager to use their right of early exercise. To be more precise most traders don’t use this option. The main target of traders is to get more money. More money comes from the difference between the selling price of a share and the original price for which this share was bought. Thus, traders are trying to sell their option and close the trade.

There are long put and call options that attract its owner not by the right for early exercise. These kinds of trades they prefer to close by selling since these trades are prone to bring more money because of the amount of time value continuing to exist in the long option lifespan. If there is much time before expiration, more time value continues to exist in the option. And when exercising the option, it leads to automatic loss of that time value.

Advantages of Early Exercise

There are two advantages of early exercise that attract investors to use this right instead of closing a trade by selling. The first is when a call option is in-the-money (ITM) and its expiration date is coming soon. Since the option may be described as an ITM option, it normally doesn’t have significant time value. The second advantage is the opportunity to exercise it earlier than the ex-dividend date comes. Holders of option don’t have rights to get dividends paid by the underlying company, thus, an early exercise lets the holders of option to reduce the time value lost because of an early exercise.

Employee stock option

There is a special kind of early exercise and that is an option, which is given to employees by a company. It’s known as an employee stock option or ESO. In case conditions let, an employee has an opportunity to exercise the given stock option even before he or she becomes fully vested. Also, when choosing the stock option, it lets an employee get more beneficial tax treatment.

Nevertheless, an employee must cover all expenses that were necessary to buy the shares as he or she doesn’t get full vested ownership. Moreover, every bought share must exist under the vesting schedule that a company stated in its plan.

Money expenses of early exercise equals expecting up after vesting (not taking into account time value of money). Nevertheless, it’s highly likely to avoid short-term taxation and the alternative minimum tax (AMT) as the payment is moved to the current time. There are still connected risks, it may happen that the shares are fully vested in the absence of the company.