This is one of the most commonly asked questions about options. The short answer is that options rarely get exercised before expiration. To fully understand why this happens we need to first understand what the terms ‘exercise’ and ‘assignment’ mean in relation to options. Then we will work through an example to evaluate when a call or put option may be exercised early.
Exercise: Only Long Options May Be Exercised
If you buy or go ‘Long’ a stock to initiate a trade you may sell that stock later to close the trade, hopefully for a profit. In options trading when you ‘Buy to Open’ (BTO) or go ‘Long’ a call or a put option, you have three choices on closing the trade:
Choice #1: Sell to Close (STC) the option, again hopefully for a profit.
Choice #2: Exercise the call or put option early. By definition if you own a call option you have the right to buy stock at the strike price of the call option. If you exercise your call option, you will be given stock at the strike price of the call option. When you exercise a put option, you have the right to sell your stock at the strike price of the put option.
Choice #3: Do nothing until option expiration. If the option is out-of-the-money (OTM)…it will expire worthless. This is not desirable because we spent money to buy to open the option and we don’t want it to lose all its value. If the option is in-the-money (ITM)…your broker will automatically exercise it for you.
Assignment: Only Short options may be assigned
If you ‘Sell to Open’ (STO) a call or a put option, you are selling a promise to do something for the buyer of that option. There are three ways to close this short option trade:
Choice #1: Buy to Close (BTC) earlier than expiration for partial profits in the option.
Choice #2: You may be assigned earlier than expiration date. This is not something you control…it happens to you under certain conditions we will explore later.
Choice #3: Do nothing until option expiration. If the option is OTM it will expire worthless. Basically you keep all the money you got at the start for selling this option and you don’t have to come through on your promise. If the option expires ITM, it will be assigned by your broker…in other words your obligation in the call or put option will now come true. For example, if you had a Short put option that expired ITM, you will be forced to buy stock at the strike of the put option.
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An example of a Call option:
Say you are trading options on a $50 per share stock. You BTO or are Long a $50 strike Call option and you paid $3 per share for this Call option expiring in 60 days.
Scenario #1: The stock moves up to $52 per share in the first 5 days.
Your call option is now ITM and goes up in value from $3 to say $4 per share. This $4 option has $2 intrinsic value and another $2 of extrinsic or time value. You now have those three choices for a long option from above:
Choice #1: STC your long call for $4 or a net profit of $1 per share.
Choice #2: Exercise your Call option early or about 55 days before expiration. If you choose to do this, your Long Call will go away along with the $3 you paid for it and you will be given the stock for $50 per share. What can you do with this stock for $50 per share? You can sell it for the current trading price of $52 per share and get $2 in your pocket. But wait…you paid $3 for the Long call and now you only get $2 back or a net loss of $1 per share. This happens because when you choose to exercise early, you lose all the extrinsic value in the option.
Sounds like we are better off with Choice #1.
Scenario #2: The stock moves up to $60 per share in the first 5 days.
Your Long Call is now deeper ITM. It is worth exactly $10 in Intrinsic Value and maybe another $0.50 in extrinsic value. The total value of this call is now $10.50 per share.
Choice #1: STC your long call for $10.50 per share or a net profit of $10.50 - $3 = $7.50 per share.
Choice #2: Exercise your Call option early or about 55 days before expiration. If you choose to do this, your Long Call will go away along with the $3 you paid for it and you will be given the stock for $50 per share. What can you do with this stock for $50 per share? You can sell it for the current trading price of $60 per share and get $10 in your pocket. Your net profit with this choice is $10 - $3 = $7 per share. Again, we lost the $0.50 extrinsic value remaining in the long call.
Again, we are better off with Choice #1.For a long call or put owner, it is always better to STC the option instead of exercising it well before expiration. This choice always gives us more profit in the amount of the extrinsic value remaining in the long option. Long option owners recognize this and usually do not exercise their options well before expiration.
So why do options get exercised early at all?
One common situation is a dividend or a special dividend announced by the stock. Now it may be worth exercising a long call option before expiration to take possession of the stock. You may lose some extrinsic value in your call option but you may gain a lot more from the special dividend payment. Another situation is when your Long option that is deep ITM and with only a few days left to expiration. In this case the remaining extrinsic value of the option is very small and the owner of the option may choose to exercise early.
Exercising your long option well before expiration is directly related to the remaining extrinsic value of the option and other circumstances like special dividends. It is almost always better to STC your long option rather than exercising it well before expiration.