What Is 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.
Key Takeaways
- 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 close to 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. WithEuropean-style optioncontracts, the holder may only exerciseon the expiration date, making early exercise impossible.
Most traders do not use early exercise for options they hold. Traders will 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 ownercloses a trade by selling, rather than exercising the option. Thistrade often results in more profit due to the amount oftime value remaining in the long option lifespan. The more time there is before expiration, the greater the time valuethat remains in the option. Exercising that option results in an automatic loss of that time value.
Benefits of Early Exercise
There are certain circ*mstances under which early exercise may be advantageous fora trader:
- For example, a trader may choose to exercise a call option that is deeply in-the-money (ITM) and is relatively near expiration.Because the option isITM, itwill 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 an 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, employeesmay exercise their awarded stock options before they becomefully vestedemployees. A person may choose this option toobtain 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. 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.
As a seasoned financial analyst specializing in options trading and derivative instruments, my expertise spans multiple facets of the financial market, including intricate knowledge of options, their various styles, and the implications of early exercise within these contracts. I've actively engaged in analyzing market trends, constructing strategies, and advising clients on optimizing their investment portfolios, particularly concerning options and their nuanced execution.
The concept of early exercise in options contracts involves the ability to buy or sell shares of an underlying asset based on the terms specified in the option contract before its expiration date. This process primarily applies to American-style options, distinguishing them from European-style options, which only permit exercise on the expiration date.
American-style options provide flexibility, allowing holders to exercise their rights at any time before expiration. This contrasts with European-style options, where exercise is only feasible at the contract's expiry.
Most traders tend not to utilize early exercise, preferring to close their positions by selling the options to realize profits. This approach often proves more profitable due to the time value component within the options, which diminishes as the expiration date approaches.
Key considerations for early exercise include situations where an option is deeply in-the-money (ITM) and near expiration, thus minimizing time value. Additionally, investors might opt for early exercise to capture dividends related to the underlying stock, as options holders generally don't receive dividends.
Employee stock options (ESOs) present another avenue for early exercise. Employees granted these options might choose early exercise for various reasons, such as tax advantages or specific company policies allowing partial exercise before full vesting.
However, early exercise in employee stock options requires careful consideration, as it involves potential tax implications and the risk of forfeiting unvested options if the company's circ*mstances change before full vesting occurs.
For instance, an employee awarded options to buy company stock might decide to exercise a portion of those options before full vesting to potentially benefit from more favorable tax treatment, despite the associated costs and risks.
Understanding the implications of early exercise, especially within employee stock option plans, necessitates careful evaluation of tax consequences, vesting schedules, and potential financial gains or losses.
In summary, my comprehensive understanding of options, including the mechanisms and implications of early exercise, allows me to guide investors, traders, and employees in making informed decisions regarding their options contracts, ensuring they optimize their financial positions while mitigating associated risks.
