When Are Calls and Puts Early Exercises?

The variety of options available to the American investor can be overwhelming.  Let’s start by answering: What are options? 

What are Options?

Options are a type of derivative security whose value is linked to an underlying asset, like a stock, commodity, future, or the like.  Investors can either buy or sell option contracts, which give the holder or owner of the option the right, but not the obligation to either buy or sell the underlying asset, at a predetermined price by a predetermined time.  The two standard types of options are calls and puts.  Many things go into the pricing of calls and puts such as time to expiration, implied volatility, and interest rates to name a few. 

Call and Put Options

Call and put options are different sides of the coin. Both are derivative contracts on an underlying asset.  However, they behave in opposite ways. Let’s break down how these options work.

What Is a Call Option?

Call options give the option buyer, or holder, the right, but not the obligation, to buy the underlying asset or instrument at a specified price within a specific time period. A call buyer profits when the underlying asset increases in price or when implied volatility increases.

A call option may be contrasted with a put option, which gives the holder the right to sell the underlying asset at a specified price on or before expiration.

What Is a Put Option?

A put option is a contract that gives the owner the right, but not the obligation, to sell (or sell short) a specified amount of an underlying asset at a predetermined price by a specified time. The predetermined price that a holder of the put option can sell the underlying asset is called the strike price.

Put options can increase in value as the underlying asset falls or when implied volatility rises. Conversely, puts decrease in value when the underlying asset rises or implied volatility declines in addition to the passage of time.

Option Exercise and Assignment:

Both calls and puts expire at some point in time, on their expiration date. When they expire, calls and puts either expire into stock or they expire worthless. Calls are in the money when the stock price is greater than the strike price. Puts expire in the money when the put strike is greater than the stock price. Holders of calls upon exercise receive long stock and holders of puts upon exercise receive short stock.  If you are short call or put options and they get assigned, you get the opposite of what a holder would get as the result of the exercise.  

Early Exercise

So, what exactly is an early exercise or assignment? Early exercise or assignment of an option occurs when a holder of either a call or put exercises the option PRIOR to the option’s expiration. The most common reason for early exercise of a call is to receive a dividend, and the most common reason for early exercise of a put is to manage interest rate exposure.  These two conditions are the most common but others exist. If you are a holder of an option, you control the exercise of the option.  If you are short an option, you can be assigned when the holder chooses to exercise an option early.

Want to learn more about the art of trading and get additional tips? Subscribe to our YouTube channel and tune in every week for new episodes of OBTV!