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 reverse: the options holder may demand that the options seller buy shares of the underlying stock at the strike price.
Key Insights
- Early exercise is the process of buying or selling shares under the terms of an options contract before the expiration date of that option.
- Early exercise is only possible with American-style options.
- Early exercise makes sense when an option is close to its strike price and near expiration.
- Employees of startups and companies can also choose to exercise their options early to avoid the alternative minimum tax (AMT).
Understanding Early Exercise
Early exercise is only possible with American-style option contracts, which the holder may exercise at any time up to expiration. With European-style option contracts, the holder may only exercise on the expiration date, making early exercise impossible.
Most traders do not use early exercise for options they hold. Traders will often take profits by selling their options and closing 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 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 that option results in an automatic loss of that time value.
Benefits of Early Exercise
There are certain circumstances under which early exercise may be advantageous for a trader:
- A trader may choose to exercise a call option that is deeply in-the-money (ITM) and is relatively near 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 options holders are not entitled to either regular or special dividends paid by the underlying company, this will enable the investor to capture that dividend. It should more than offset the marginal time value lost due to early exercise.
Early Exercise and Employee Options
There is another type of early exercise that pertains to company-awarded stock options (ESO) given to employees. If the particular plan allows, employees may exercise their awarded stock options before they become fully vested employees. A person may choose this option to obtain a more favorable tax treatment.
However, the employee will have to foot the cost to buy the shares before taking full vested ownership. 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. However, since the payment is shifted to the present, it may be possible to 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.
Early Exercise Example
Suppose an employee is awarded 10,000 options to buy company ABC’s stock at $10 per share, which vest after two years.
The employee exercises 5,000 of those options to purchase ABC’s stock, valued at $15, after a year. Exercising those options will incur $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 the requirements for long-term capital gains tax.
Related Terms: stock options, call options, put options, capital gains tax, American-style options.
References
- Financial Industry Regulatory Authority. “Options: Types”.
- Financial Industry Regulatory Authority. “Trading Options: Understanding Assignment”.
- Financial Industry Regulatory Authority. “Options: Risk”.
- Titan. “How to Exercise Employee Stock Options”.
- Internal Revenue Service. “Form 6251, Alternative Minimum Tax - Individuals”. Page 1.
- Internal Revenue Service. “Topic No. 409, Capital Gains and Losses”.
