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Early exercise happens when the owner of a call or put invokes his or her contractual rights before expiration. As a result, an option seller will be assigned, shares of stock will change hands, and the result is not always pretty for the seller.
Being required to buy or sell shares of stock before you originally expected to do so can impact the potential risk or reward of your overall position and become a major headache. Many traders fail to plan for this possibility and feel like their strategy is falling apart when it does happen. The strategies that can be messed up the most by early assignment tend to be multi-leg strategies like short spreads , butterflies , long calendar spreads and diagonal spreads.
However, there are a few instances when exercising early does make sense. But understanding the pros and cons of early exercise can make you more aware of when you might be at risk of early assignment. The likelihood of a short option being assigned early depends on whether the option you sold is a call or a put. If you own a call, your risk is limited to the amount you paid for the option, even if the stock drops to zero.
If your call is in-the-money prior to expiration, it makes little sense to exercise early. In this case, you could have let the option expire worthless and bought the stock at a lower price on the open market. So why not keep your cash in an interest-bearing account for as long as possible before you pay for those shares? Disciplined investors look for every opportunity to achieve maximum return on their assets, and this one happens to be a complete no-brainer.
If there is any time value, the call will be trading for more than the amount it is in-the-money. So if you want to own the stock immediately, you could simply sell the call and then apply the proceeds to the purchase of the shares.
The exception to these three rules occurs when a dividend is going to be paid on the stock. Call buyers are not entitled to dividend payments, so if you want to receive the dividend, you have to exercise the in-the-money call and become a stock owner. But you have to do so prior to the ex-dividend date.
In the case of puts, the game changes. So it can be tempting to get cash now as opposed to getting cash later. However, once again you must factor time value into the equation. As opposed to calls, an approaching ex-dividend date can be a deterrent against early exercise for puts. By exercising the put, the owner will receive cash now. So exercising a put option the day before an ex-dividend date means the put owner will have to pay the dividend.
Early assignment on a short option in a multi-leg strategy can really pull a leg out from under your play. They have nothing to do with where the options are traded. In fact, both American- and European-style options are traded on U. The different styles simply refer to when the options may be exercised and assigned. American-style options can be exercised by the owner at any time before expiration. Thus, the seller of an American-style option may be assigned at any time before expiration.
As of this writing, all equity options are American-style contracts. And generally speaking, options based on exchange-traded funds ETFs are also American-style contracts.
Most index options are European-style. Options involve risk and are not suitable for all investors. For more information, please review the Characteristics and Risks of Standardized Options brochure before you begin trading options. Options investors may lose the entire amount of their investment in a relatively short period of time.
Multiple leg options strategies involve additional risks , and may result in complex tax treatments. Please consult a tax professional prior to implementing these strategies. Implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or the probability of reaching a specific price point.
The Greeks represent the consensus of the marketplace as to how the option will react to changes in certain variables associated with the pricing of an option contract. There is no guarantee that the forecasts of implied volatility or the Greeks will be correct. Ally Invest provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice.
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The Options Playbook Featuring 40 options strategies for bulls, bears, rookies, all-stars and everyone in between. What is Early Exercise and Assignment? Three Reasons Not to Exercise Calls Early Keep your risk limited If you own a call, your risk is limited to the amount you paid for the option, even if the stock drops to zero. One circumstance when it might make sense to exercise a call early: Puts are at greater risk of early assignment as time value becomes negligible In the case of puts, the game changes.
Dividends as a deterrent against early put exercise As opposed to calls, an approaching ex-dividend date can be a deterrent against early exercise for puts. What to do if you're assigned early on a short option in a multi-leg strategy Early assignment on a short option in a multi-leg strategy can really pull a leg out from under your play.
Back to the top. Keeping an Eye on Position Delta.