Early Exercise
The process of the buying and/or selling shares of a particular stock that include the underlying terms of a corresponding options contract until its expiration date
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What is Early Exercise?
Early exercise refers specifically to options contracts. The early exercise of an options contract refers to the process of buying and/or selling shares of a particular stock that include the underlying terms of a corresponding options contract before its expiration date.
Summary
- The early exercise of an options contract refers to the process of buying and/or selling shares of a particular stock that include the underlying terms of a corresponding options contract before its expiration date.
- Exercising an option simply refers to the act of putting into effect the right, but not the obligation, to buy or sell the underlying financial security of the corresponding options contract.
- Early exercise works only with American-style options contracts and not with European-style options contracts.
How It Works
The underlying terms of an options contract work in a straightforward fashion:
- For call options, the options contract holder holds the right to demand the purchase of shares of the underlying stock at the strike price.
- For put options, the options contract holder holds the right to demand the sale of the shares of the underlying stock at the strike price.
What is an Options Contract?
An options contract is a form of a financial derivative (i.e., a financial contract between two parties whose value is derived from underlying assets, like foreign currency holdings, stock, bonds, etc.), a contract that grants the buyer the right, but not the obligation associated with it to purchase or sell the underlying asset at a set price, on or before a specific date. The set price is referred to as the strike price.
What are Call and Put Options?
A call option gives the trader the right, but not the obligation, to buy an underlying asset (stock, bond, commodity, etc.) at a specific price (strike price), on or before a specific date.
A put option grants the trader the right, but not the obligation, to sell an underlying asset at the strike price on or before a specific date.
Based on the proximity of an option’s strike price to its stock price, it can either be classified as:
- An In The Money (ITM) option
- An Out of The Money (OTM) option
- An At the Money (ATM) option
In the Money (ITM) Options
In the money (ITM) options are important from the early exercise point of view.
A call option is in the money if the current value (or spot price) of the underlying asset is more than the strike price of the options contract, i.e.,
Call Option (In The Money): Spot Price > Strike Price
On the contrary, a put option is in the money if the current value, the spot price, of the underlying asset is less than the strike price of the options contract, i.e.,
Put Option (In The Money): Spot Price < Strike Price
What is an Options “Exercise”?
In the world of finance and investment, “exercising” an option simply refers to the act of putting into effect the right, but not the obligation, to buy or sell, i.e., exercising the right available with the options contract holder to buy or sell, the underlying financial security of the corresponding options contract.
Applications of Early Exercise
Early exercise works only with American-style options contracts and not with European-style options contracts. This is because American-style options contracts can be exercised at any time up to the contract’s expiration date.
However, with European contracts, the options contract holder may only exercise on and only on the expiration date. It is why early exercise is impossible for European-style options contracts; exercise is not allowed at any time before the expiration date.
Early exercise is a very common exercise strategy when it comes to large quantities of in-the-money (ITM) call options. It is because there is a significant trading benefit associated with exercising ITM call options early, as it renders substantial profit margins.
Related Readings
CFI is the official provider of the global Capital Markets & Securities Analyst (CMSA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:
