Article - Getting Exercised Early

Under what conditions am I at risk of early exercise of my equity options?

The ASX quotes that "On average less than 15% of all taken options are exercised. The remaining 85% or so either expire unexercised or are closed out".

Although it can and does happen, it is not often that an option is exercised until close to its expiry day. So why would the holder of an option exercise early.

Consider a Call Option: If a Call option is deep in the money, i.e. the stock price is well above the strike price of the Call Option, then the writer (seller) of the Call Option can be at risk of early exercise if... there is a dividend payable on the stock before expiry and the value of the dividend is greater than the "cost of carrying the stock".

In this case the "cost of carrying the stock" is the interest expense on the capital to buy the stock.

So in simple terms, if I am the taker of a Call Options (bought a call options) and the dividend is more than how much it would cost to buy the stock early, then I might exercise early.

Consider a Put Option: If a Put option is deep in the money, i.e. the stock price is well below the strike price of the Put Option, then the writer (seller) of the Put Option can be at risk of early exercise if... the corresponding cost of a Call Option is less than the "cost of carrying the stock".

In this case the "cost of carrying the stock" is the interest expense on the capital to hold the stock.

The reason that we compare to the cost of the corresponding Call Option is because if you compare a) a long Call Option with b) Holding stock and a long Put option, these have the same risk/reward.  Check out the Payoff diagrams for these two types of positions in Paper-Trader to see the risk/reward.

So in simple terms, if a) is less than b) then you are at risk of early exercise of your Put Options.

Typically short Put positions are at a higher risk of early exercise short Call positions.

 

Notes:

1. Interest expense is calculated by: (Price in cents x Cash rate %) รท (365 x Days to expiry)

2. Long means that you have bought to open the position.

Article by Richard Baartz
Paper-Trader... Accelerated Stock Market Learning
 

Article link: http://paper-trader.com/getting_exercised_early.php

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