What Is Early Exercise?
Let me explain early exercise of an options contract directly to you: it's the process where you buy or sell shares of stock according to the terms of that option before its expiration date. If you're holding a call option, you can demand that the seller provides shares of the underlying stock at the strike price. For put options, it's the reverse—you can force the seller to buy shares from you at the strike price.
Key Takeaways
- Early exercise means buying or selling shares under an options contract before the expiration date.
- This is only possible with American-style options.
- It makes sense when an option is close to its strike price and nearing expiration.
- Employees at startups or companies can exercise options early to sidestep the alternative minimum tax (AMT).
Understanding Early Exercise
You should know that early exercise is exclusive to American-style option contracts, which you can exercise anytime up to expiration. European-style ones? You can only exercise them on the expiration date, so early exercise isn't an option there.
Most traders I know don't bother with early exercise for their held options. Instead, they sell the options to close the trade and pocket the profit from the difference between the selling price and what they originally paid.
If you have a long call or put, closing by selling is usually better than exercising because it captures the remaining time value in the option's lifespan. The more time left before expiration, the higher that time value, and exercising wipes it out automatically.
Benefits of Early Exercise
There are specific situations where early exercise can work in your favor as a trader. For instance, if you have a call option that's deeply in-the-money and close to expiration, exercising might be smart since the time value is negligible at that point.
Another case is when the underlying stock has an upcoming ex-dividend date. As an options holder, you don't get dividends directly, so exercising early lets you own the stock and capture that dividend, which should outweigh any small time value you lose.
Early Exercise and Employee Options
There's also early exercise in the context of company-awarded stock options for employees. If the plan permits it, you can exercise these options before they're fully vested.
You might do this for better tax treatment, but you'll need to pay upfront to buy the shares, and those shares still have to follow the company's vesting schedule.
The cost is the same as waiting until vesting, ignoring time value of money, but doing it early could help you avoid short-term taxes and the AMT. Keep in mind, though, it adds risk if the company folds before full vesting.
Early Exercise Example
Consider this scenario: Suppose you're an employee awarded 10,000 options to buy company ABC's stock at $10 per share, vesting after two years.
After one year, you exercise 5,000 options when the stock is at $15. That costs you $7,000 based on a 28% federal AMT rate. But by holding those exercised options for another year, you can qualify for long-term capital gains tax and lower your federal tax percentage.
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