Definition
The term early exercise refers to a feature of American options that permit the holder to exercise the option prior to its expiration date. While most index options are of the European-style, options involving equities are typically of the American-style.
Explanation
While European options can only be exercised on their expiration date, American-style options allow holders to exercise the option prior to its expiration date. Early exercise of a call option allows the holder to purchase the underlying asset, or stock, at the strike price prior to expiration. Early exercise of a put option allows the holder to sell the underlying asset, or stock, at the strike price prior to expiration.
The total value of an option includes both an intrinsic as well as extrinsic component. The extrinsic value of an option is equal to its moneyness, while the intrinsic value of an option is a function of the volatility of the underlying asset and the option's time to expiration. When an option is exercised early, the investor is giving up the intrinsic value of the option. For this reason, and under most circumstances, it's not advisable to exercise an option early. However, under certain conditions the early exercise of an option may be advantageous:
Interest Income: when interest rates are sufficiently high, a holder of a put option may be better off exercising their right to sell the stock at the strike price prior to the option's expiration date and allow the cash from the transaction to generate additional interest income.
Capture Dividends: since the holder of a stock on the ex-dividend date is entitled to receive the cash dividend, the holder of an in-the-money call option may be better off exercising their right to purchase the stock prior to the option's expiration date and capture the dividend.
Related Terms
The term equivalent strategy refers to two positions that share the same risk and reward profile. When two traders assume different, but equivalent strategies, they will share the same payoff.
Moneyzine EditorNovember 6th, 2024
The term equity option refers to a call or put involving an individual common stock or exchange traded fund (ETF). Equity options are considered equity derivatives and are the most common type of this contract.Moneyzine EditorNovember 6th, 2024
The term diagonal spread refers to a strategy that involves the simultaneous purchase and writing of two options of the same type with different strike prices and expiration dates. Diagonal spreads also involve the same underlying asset.Moneyzine EditorJanuary 16th, 2024
The term derivative refers to a financial contract that derives a portion of its value and characteristics from an underlying asset. Derivatives have no value other than the expected future price movements of the underlying asset.Moneyzine EditorNovember 6th, 2024
