Early Exercise
Early exercise of an options contract is the process of buying or selling shares of stock under the terms of that option contract before its expiration date. For call options, the options holder can demand that the options seller sell shares of the underlying stock at the strike price. For put options it is the converse: the options holder may demand that the options seller buy shares of the underlying stock at the strike price.
Early Exercise
Definition
Early exercise of an options contract refers to the process of buying or selling stock according to the contract terms before the option's expiration date. For a call option, the option holder can require the option seller to sell the underlying stock at the strike price; for a put option, the option holder can require the option seller to buy the underlying stock at the strike price.
Origin
The concept of early exercise originated with the development of the options market. The earliest options market can be traced back to the 17th-century Dutch tulip bubble, but the modern options market began with the establishment of the Chicago Board Options Exchange (CBOE) in 1973. As options trading became more widespread, investors recognized the potential advantages of early exercise under certain market conditions.
Categories and Characteristics
Early exercise can be divided into two main categories: early exercise of call options and early exercise of put options.
- Early exercise of call options: When the price of the underlying stock rises significantly, the option holder may choose to exercise early to lock in profits or receive dividends.
- Early exercise of put options: When the price of the underlying stock falls significantly, the option holder may choose to exercise early to avoid further losses or utilize tax strategies.
Specific Cases
Case 1: Suppose Investor A holds a call option with a strike price of $50, and the current price of the underlying stock is $60. A decides to exercise early, buying the stock at $50 and selling it at the market price of $60, thus making a $10 profit.
Case 2: Suppose Investor B holds a put option with a strike price of $40, and the current price of the underlying stock is $30. B decides to exercise early, selling the stock at $40 to avoid further losses from a price decline.
Common Questions
Q1: Is early exercise always beneficial?
A1: Not necessarily. The decision to exercise early should be based on market conditions, time value, and transaction costs.
Q2: Does early exercise affect the time value of the option?
A2: Yes. Early exercise typically results in the loss of the option's time value, so it requires careful consideration.
