Learn more about when you’d want to exercise options early and how it can impact your taxes.
Definition and Examples of Early Exercise of Options
Options grant the holder the right, but not the obligation, to buy or sell a stock at a strike price by the maturity date. The right to buy a stock is called a call option, and the right to sell is called a put option. Exercising a stock option is when you either buy the underlying security for call options or sell it for put options. So when you exercise a stock option early, you either buy or sell it before the option’s maturity date. Let’s say an investor owns three option contracts of a stock that trades well above the strike price and they want to buy the stock before the options’ maturity dates to gain access to its dividend. The investor could exercise the options contracts early and buy the stock at the strike price at that time.
Over-the-Counter Options Market
In the over-the-counter options market, where more customization is possible for bespoke contracts, there are two other kinds of options: Canary Options Canary options are close to European Options (as the Canary Islands are closer to Europe than to America), may give the option holder the right to exercise the option one or two additional times during the life of the contract. It’s not a “continuous” right like an American style option but gives the owner a little bit more choice. Bermuda Options Bermuda options are closer to American style (as Bermuda is much closer to America than to Europe), in that they may be exercisable much more frequently—perhaps weekly or bi-weekly, depending on the terms of the contract. All things being equal—the underlying, strike price, maturity, etc.—European style options are cheaper than a comparable Canary option, which would be cheaper than the Bermuda option, which would be less than the American-style option. All because the more flexibility the owner of the option has, the more they have to pay for that privilege. In-the-money options are generally exercised automatically at the maturity dates.
Early Exercise of Employee Stock Options (ESOs)
Early exercise of options is also an important concept in regard to employee stock options (ESOs). Employee stock options are call options issued to employees as incentives and typically have artificially low strike prices. Employees of recent start-ups may be able to exercise their stock early and buy shares while the value of the company is low. The higher the valuation of the start-up when options are exercised, the higher the related tax bill because employees must report the difference between the exercise price and the fair market value on their alternative minimum tax (AMT) calculation. Additionally, the IRS has a holding period requirement (which starts when the options are exercised) to be able to report proceeds from the sale of stock purchased through an employee stock option plan as capital gain and not wages.
How Early Exercise of Options Works
Early exercise of an option can make financial sense in some cases, such as when the stock is close to its strike price or the option is nearing its expiration date, or when selling an employee option early can help you avoid the alternative minimum tax (AMT). Option prices are made up of two components: time value and intrinsic value. Intrinsic value is the difference between the underlying stock’s current price and the strike price. Time value is the value the market gives to future potential gains. If the market thinks a stock will rise to $20 per share, the option may trade for $10 even if the intrinsic value of it is $5. So if the option trades for $10 and the holder only gains $5 by exercising it early, it makes more sense to sell it on the open market for $10, then buy the stock in a separate transaction than to exercise early. There are a few instances where it may make sense to exercise an option early. They include:
Low time value: If the option is close to the maturity date, it may have little to no time value. This happens often with stocks that have low volatility to start with. In this instance, the time value may be low enough to be immaterial in the exercise decision. Ex-dividend date: Option holders do not get to participate in a stock’s dividends. Holders of a call option who know they will exercise eventually may want to exercise before the ex-dividend date (the date when you have to hold the stock to get the dividend). This makes sense in theory, but only in practice if the time value of the option is immaterial. If there is still time value, it may make more sense to sell the option and buy the stock in a separate transaction. Employee stock options: For employees of start-ups, it may make sense to exercise employee stock options early for tax benefits. If you hold employee stock options, consider talking to your financial advisor to determine the best plan for your holdings.
To exercise an option, the investor submits instructions to their broker, who then sends the instructions to the Option Clearing Corporation (OCC), which assigns the exercise to a specific counterparty. The transaction then is executed. If a call option is exercised, the buyer’s cost basis (for tax purposes) is equal to the strike price of the option plus the premium paid to purchase the option. If a put is exercised, the sale price is equal to the strike price minus the option premium.
