When does it make sense to exercise an option early?
The answer is that it generally does not make sense – unless the option is: a) Deep in the money and/or b) Very close to expiration.
It is a worthwhile effort to “do the math” on exercising an option early. Let’s say that I bought RIMM stock at $75.00 (back in April when a short put was assigned.)
As a smart OptionsAnimal trader, I bought a protective put. (…and I have traded those puts over the past few months.) For the sake of simplicity, let’s look at the basic application of the Protective Put. That is: Long Stock with one Put purchased “at the money” with at least 45 days of time value. On JUL 30, I purchased at DEC 55 Put for $7.55. Today, RIMM is trading at 47.72. My DEC 55 long put is trading at 9.85. My cost basis in the stock is: Debit for stock $ (75.00) Debit for DEC 55 LP $ (5.25) Cost Basis $ (80.25)
Today, I have two choices. I can exercise the long put: to sell my stock at the strike price or I can just close the trade. If I exercise my long put I can sell the stock for $55, as compared to the market price of $47.72. To the novice investor, selling at $55 seems like the better deal. But let’s compare the alternatives. Exercise the put: Credit for exercising put – sell stock at 55 $ 55.00 Net Profit/Loss $ (25.25) Sell everything: Sell stock at the market price $ 47.72 Credit for selling DEC 55 LP $ 9.85 Net Profit/Loss $ (22.68)
For comparison purpose, if I just held the stock, I would have a net loss of $27.28. [This would be disappointing if this was the only trade that I did. But, because I have been collar trading RIMM, I am actually down only $4.15. A loss is disappointing, but I am confident that I will turn this to a profit, by continuing to manage the collar trade. ] Back to the issue at hand. You can see that by exercising, I am taking a $25.25 loss. Versus selling the positions, I am taking loss of $22.68 loss. You can see that by exercising I am giving up an extra $2.57. So, in this situation you can see that exercising early does not make sense. Now, time for the “bonus round” folks. What does that $2.57 represent?
It is exactly equal to the extrinsic value in the option. So, if you exercise an option early, you sacrifice the extrinsic value of the option. If you were on the other side of that trade – the option seller – you would be thrilled if the buyer decided to exercise early. If you sold the put, you were probably bullish (unless it was part of another trade.) Now you were looking at potentially buying back that put, for a significant loss. Credit for selling DEC 55 LP $ 5.25 Debit to buy back DEC 55 LP $ (9.85) Net Profit/Loss $ (4.60) If you found yourself assigned, you would be put the stock and could immediately sell it. Credit for selling DEC 55 LP $ 5.25 Debit to buy stock at 55 $ (55.00) Credit for selling stock $ 47.72 Net Profit/Loss $ (2.03)
The difference between the two situations. Yes, you guessed it: $2.57. That is the extrinsic value. The option buyer just gave you a gift. You can do the math for calls (and you should do the math) to see that it’s a similar situation. The bottom line is that when there is significant extrinsic value, it rarely makes sense to exercise an option early. Unless your option is deep in the money or very close to expiration – when the extrinsic value is nearly zero – it does not make sense. And if you are the option seller, assignment is unlikely when there is significant extrinsic value. That does not mean that it cannot happen. Anyone who buys an option has the right to exercise it. If you are the seller, you can find yourself assigned. It happens. I have neglected the issue of “carrying cost” (i.e., interest) and “transaction costs” (i.e., commissions and fees.)
Those need to be considered and may help you make the decision as to whether it is better to exercise or sell. BUT IT DOES HAPPEN! For call sellers, the most likely scenario of assignment is for dividend paying stocks when the short call is deep in the money. The rule of thumb is that if the price of the put, at the same strike as the short call, is less than the dividend to be paid, assignment of a short call is likely. DON’T PANIC! If having your stock trend “in the money” is part of your trading plan, don’t panic. I always chuckle when a student says – in a frantic tone – “I did a Covered Call and now my short is in the money. Should I close the trade?” The first question is: What was your primary exit? “Assignment of the short call.” Relax. No need to panic.
When assignment happens, you win! If the short is going in the money, there may be reason for concern. But generally, that’s not because of risk of early assignment. Generally, that means that your trade went against you and you probably need to be considering your secondary exits. That is why I always say “Always define your primary and secondary exits.”