Early Exercise

What Is Early Exercise?

Early exercise is the act of exercising an options contract before its expiration date. It is only possible with American-style options (which can be exercised at any time up to expiration). European-style options can be exercised only at expiration, so early exercise is not available.

Most traders do not exercise early because doing so destroys the option’s remaining time value. Instead, they usually sell the option to close the position and capture the time value plus any intrinsic value.

How Early Exercise Works

• American-style options: holder may exercise at any time up to expiration.
• European-style options: exercise only at expiration (no early exercise).
• Time value loss: exercising converts an option into shares (or a short position for puts) and eliminates any remaining time value, which often makes exercising suboptimal for traders.
• Typical practice: long calls or puts are usually closed by selling the option rather than exercising, unless specific conditions make exercising preferable.

When Early Exercise Can Make Sense

Early exercise can be advantageous in specific situations:

• Deep in-the-money (ITM) options near expiration: if time value is negligible, exercising may be effectively equivalent to selling the option.
• Capturing dividends: option holders do not receive dividends. Exercising a call before the stock’s ex-dividend date can allow the holder to receive the dividend, which can offset the time value lost by exercising.
• Strategic ownership needs: a trader may want to become a shareholder (to vote, short-sell, or use shares for other strategies) and thus decide to exercise.

Early Exercise for Employee Stock Options (ESOs)

Employees sometimes have the contractual right to early exercise company-granted stock options before they fully vest. Key points to consider:

• Upfront cash required: exercising requires paying the strike price for the shares immediately.
• Vesting rules: even if exercised early, the shares may remain subject to the employer’s vesting schedule and potential repurchase provisions.
• Tax considerations: for incentive stock options (ISOs), early exercise can create an AMT (alternative minimum tax) preference item equal to the bargain element (market price minus strike) at exercise. Paying AMT may be a short-term cost that can enable longer-term capital gains treatment if the holding-period rules are met. For non-qualified options, exercising usually generates ordinary income on the bargain element at exercise.
• Risk: exercising early carries the risk that the company’s value could decline or the employee could leave before vesting, potentially losing the cost paid.

Illustrative (Simplified) Example

• Award: 10,000 options, strike $10, vest after 2 years.
• Scenario: after 1 year the market price is $15. The bargain element per exercised share is $5. If the employee exercises 5,000 options, the bargain element is 5,000 × $5 = $25,000.
• AMT example: if the bargain element is subject to AMT at 28%, the AMT liability on that preference item could be about $7,000 (25,000 × 0.28). Holding the shares long enough to meet long-term capital gains requirements may reduce future tax on appreciation, but it does not eliminate the early AMT exposure and the upfront cash requirement.

Practical Considerations

• Compare selling the option versus exercising: selling preserves time value; exercising converts to shares and removes time value.
• Transaction costs and liquidity: consider commissions, bid-ask spreads, and the ability to execute a sale.
• Dividends and corporate events: imminent dividends, mergers, or other corporate actions can change the calculus.
• Tax and personal finances: tax consequences differ by option type (ISOs vs. non-qualified) and by individual circumstances; early exercise requires sufficient cash and tolerance for holding company stock. Consult a tax advisor when uncertain.

Bottom Line

Early exercise is a specialized tool rather than a default move. For traded options, selling the option is usually preferable because it preserves time value. Early exercise can be rational when an option is deep ITM with little time value, when capturing a dividend offsets the lost time value, or when employees pursue tax or ownership objectives with company stock options. Evaluate time value, dividends, transaction costs, and tax implications before deciding to exercise early.