Introduction
Options are financial derivatives that allow but don’t oblige you to buy or sell underlying securities at a predetermined price within a specified period. Early exercise is a stock trading strategy specifically for option contracts.
What is an early exercise in trading?
Early exercise is buying or selling shares from an options contract before its expiration date. So, if the options contract expires on November 18, 2023, you can implement an early exercise to sell it beforehand.
Call options give you the right to demand that the options seller sell the shares of the underlying asset at the strike price. On the contrary, put options give you the right to demand that the options seller buy shares at the strike price determined in the contract.
Open Trading Account and Start Trading!
Before you decide to go for an early exercise, make sure you evaluate the option’s current market price, the cost of holding the position, the time remaining until expiration, dividend payments, and your trading strategy. You can determine the right time to exercise options using mathematical models and financial analysis.
How does it work?
Suppose you hold a put option for the stocks of ABC company at a strike price of Rs. 500 and an expiration date in two weeks. The stock’s current price is Rs. 450, and the option is in the money.
But news updates signal a decline in ABC’s stock, so consider exercising the put option early to avoid potential losses.
With your decision to exercise the put option early, you demand that the options seller buy stocks of ABC company from you at the strike price of Rs. 500. As the current market price of the stock is Rs. 450, you can sell the shares at a price higher than the current market price.
The strategy of early exercise allows you to earn a strike price of Rs. 500 per share from the options seller. Consequently, you can earn a profit of Rs. 50 per share for your holdings.
Benefits of early exercise
Depending on your investment strategy, You can exercise an option early. The benefits you will reap with your action are as follows:
- Capture dividends: Early exercise lets you capture dividends the underlying asset pays. When you exercise a call option before the expiry date, you become a shareholder in the company. Consequently, you are entitled to the dividend payment.
- Mitigate risks: The options trading strategy helps you manage risks and mitigate potential losses. If you have a deep-in-the-money put option, early exercise gives you the right to sell the underlying asset at the strike price and restrict the risk of potential loss.
- Capitalise on market opportunities: You can exploit specific opportunities with early exercise. Suppose a news update has a favourable impact on the underlying asset or brings a sudden drop in its price. You can exercise an option early to secure profits or minimise potential losses.
- Increase liquidity and flexibility: Early exercise allows you to convert your options contracts into shares of the underlying asset, thereby increasing liquidity and flexibility. If you have a medical emergency and your put option is in the money, you don’t need to wait till the expiration. You can do an early exercise and sell your shares to pull out your investment.
Factors to consider
You must consider certain factors before you decide to exercise early. These factors include taxes, transaction costs, and overall risk-reward.
- Taxes: Before going for an early exercise, determine the duration you’ve held the investment. Will you have to pay Short-term Capital Gains (STCG) or Long-term Capital Gains (LTCG)? Check the calculations to understand if you must pay tax before exercising an option early.
- Compare with returns from selling: In some cases, you can sell the options contract at a higher rate to traders desiring to buy the company’s shares or willing to implement an early exercise. Compare the difference in returns between early exercise and selling the contract to another party. The idea is relevant if you have read some news that makes you want to hold the shares for a steeper uptrend.
Conclusion
If you want to exercise an option early, you must understand the terms and conditions of the specific options contract. It will be beneficial to go with the strategy if the underlying stock pays a good dividend and the dividend amount is more than the remaining time value in the option. The strategy is common for large quantities of in-the-money (ITM) call options. However, it is not recommended when the cost exceeds the potential benefits.
Related Articles: A Detailed Guide to E-Micro Forex Futures | Understanding Group A stocks on BSE | Nuances of International ETF | Guide to Investing In Cash Management Bills
Popular Stocks: HDFC Bank share price | ICICI Bank Share Price | UPL Share Price | Tata Consumer Share Price | Divislab Share Price