Introduction

In the world of options trading, the concept of early exercise plays a crucial role in understanding the behavior of American call and put options. Unlike European options, which can only be exercised at expiration, American options grant holders the flexibility to exercise their options at any point before expiration. This chapter delves into the rationale behind early exercise decisions, exploring the factors that influence when and why option holders might choose to exercise their American call and put options before the expiration date.

Exploring Early Exercise and Its Significance

Early exercise refers to the act of an option holder exercising their option before its expiration date. This feature introduces a layer of complexity to option valuation as it involves estimating the optimal timing for exercising an option. The decision to exercise early is influenced by several factors including time remaining until expiration, underlying asset’s price movement, interest rates, and dividend payments.

Rationales for Early Exercise of American Call Options

Early exercise of American call options is driven by the opportunity to capture dividends or exploit sudden changes in the underlying stock’s price. When a stock goes ex-dividend, its price tends to drop by the amount of the dividend. In cases where the dividend is relatively large and the option’s remaining time to expiration is short, it might be advantageous for the option holder to exercise the call option early and capture the dividend.

Example: Suppose an investor holds an American call option on a stock that is about to go ex-dividend. If the dividend is significant and the option is deep in-the-money, exercising the option before the ex-dividend date could be more profitable than waiting until expiration.

Rationales for Early Exercise of American Put Options

American put options, on the other hand, offer the possibility of early exercise when the underlying stock’s price experiences a significant drop. If the put option is in-the-money and the investor believes that the stock’s price is likely to rebound, early exercise can help the investor lock in the gains from the option.

Example: Imagine an investor holds an American put option on a stock that experiences a sudden and sharp decline in its price due to negative news. If the put option is in-the-money, the investor might exercise the option early to realize profits from the option and avoid further potential losses if the stock rebounds.

Assessing the Decision to Early Exercise

The decision of whether to early exercise an American option is not always straightforward. Option holders need to consider factors such as transaction costs, potential tax implications, and the time value of money. Additionally, early exercise can lead to missed opportunities for further gains if the underlying asset’s price continues to move favorably.

Example: An investor holding an American call option that is slightly out-of-the-money might choose not to exercise early, even if a dividend is approaching, if the cost of exercising the option outweighs the potential dividend gains.