Benefits and Strategies for Call Options

What Is Early Exercise?

Owners of options contracts have the right to exercise their options early, thereby purchasing or selling the shares underlying a contract before its expiration date. Early exercise is only available for American-style options and is not commonly used due to potential loss of time value. However, it can be strategic in specific circumstances, like ITM options or upcoming dividend payments.

How Early Exercise Works in Options Trading

Early exercise is only possible with American-style option contracts, which the holder may exercise at any time up to expiration. European-style options can only be exercised on the expiration date, so early exercise is not possible.

Most traders do not use early exercise for options they hold. Traders often take profits by selling their options to close out the trade. Their goal is to realize a profit from the difference between the selling price and their original option purchase price. 

For a long call or put, the owner closes a trade by selling, rather than exercising the option. This trade often results in more profit due to the amount of time value remaining in the long option lifespan. The more time there is before expiration, the greater the time value that remains in the option. Exercising the option leads to an automatic loss of its time value.

Advantages and Scenarios for Early Exercise

Early exercise can be beneficial for a trader in certain situations:

• For example, a trader might exercise a call option that is deeply in-the-money (ITM) and close to expiration. Because the option is ITM, it will typically have negligible time value.
• Another reason for early exercise may be a pending ex-dividend date of the underlying stock. Since option holders aren’t entitled to dividends, exercising early lets them capture the dividend. It should more than offset the marginal time value lost due to an early exercise.

Early Exercise for Employee Stock Options

There is another type of early exercise that pertains to company awarded stock options (ESO) given to employees. If allowed, employees can exercise their awarded stock options before they fully vest. A person may choose this option to obtain a more favorable tax treatment.

However, the employee must cover the cost to buy shares before fully vesting. Also, any purchased shares must still follow the vesting schedule of the company’s plan.

The money outlay of early exercise within a company plan is the same as waiting until after vesting, ignoring the time value of money. Since the payment moves to the present, this might help avoid short-term taxation and the alternative minimum tax (AMT). Of course, it does introduce the risk that the company may not be around when the shares are fully vested.

Illustrative Example of Early Exercise

Suppose an employee is awarded 10,000 options to buy company ABC’s stock at $10 per share. They vest after two years.

The employee exercises 5,000 of those options to purchase ABC’s stock, which is valued at $15, after a year. Exercising those options will cost $7,000 based on a federal AMT rate of 28%. However, the employee can reduce the federal tax percentage by holding onto the exercised options for another year to meet requirements for long-term capital gains tax.

The Bottom Line

Early exercise allows options holders to buy or sell shares before an option’s expiration date, and applies only to American-style options. There are strategic reasons for early exercise, such as capturing in-the-money profits or taking advantage of ex-dividend dates. Employees with stock options who contemplate early exercise have unique considerations, such as tax benefits and the necessity of adhering to vesting schedules. With long options, it’s important to evaluate the potential gain versus the loss of time value.