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Early Exercise: Call Options


How would a trader like you decide to do early exercise? Say you bought calls when they were trading in the 1.0 -> 2.5 range, now underlying has risen so that calls trade bid-ask at 4.0 / 4.8 and there is strong possibility of it going higher. Also assume in another case that they trade in the 6.0 to 7.0 range.

What would make you wait for early exercise till Wednesday morning, Thursday morning, Friday morning of expiry week as a trader? Assume you have cash to buy all contracts. The time value is negligible, and theta is eroding it fast.

 

Would you change your mind if the risk-free interest rate was say 8% and not 0-1% as currently?  Is that rate a huge factor for 2-4 days anyway?

 

I read some books where a bunch of math experts say that except for a dividend-paying underlying, early exercise is impossible.

 

Personally, if I were the call buyer and I had bazillion money, I would not sell the calls as the bid/ask spread widens and the market makers play games. I would choose early exercise sometime on late Wednesday or anytime Thursday to remove option spread slippage, so I buy underlying at the strike price and immediately sell it to lock in profit, because underlying spread is narrower than the option spread.

 

Answer:

 

This is a very easy question.

 

1) I WOULD NEVER, exercise a call option prior to expiration – UNLESS it is to capture a dividend.

 

Before I go further, there are three valid reasons why someone may want to exercise a call option early.  My guess is that >99% of all option traders will never encounter these situations. 

 

  1. If there is a dividend, sometimes a call owner must exercise the option or it is throwing money into the trash.  The call must be ITM, the delta must be 100 and the option should not be trading over parity. 
  2. A professional trader (market maker) may prefer to sell stock short to hedge some trades.  If he/she does not own long stock, then when expiration is near,  deep ITM calls can be exercised and the long stock immediately sold. That is not as good as selling short stock, but must suffice when there are no better alternatives.
  3. When expiration is near and the call option is deep ITM, sometimes the option bid is below parity.  In that situation – and it is not that common because most traders do not hold onto options that move deep into the money – then it's often better to exercise and immediately sell stock than it is to sell the call. 
  4. Selling the call is preferable because it saves commission dollars.  But if the bid is too low, then the trader may have to exercise.

These situations exist, and I mention them for the purist.  However, my contention remains that if you are a retail investor, you can easily go your entire lifetime and never exercise a call option – or have any reason to do so.

 

A smart retail trader NEVER exercises a call option.  What can be gained?  Think about it.  Why would anyone prefer to own stock and suddenly have downside risk.

 

If you are assigned an exercise notice on a call option prior to expiration, consider it to be a gift (unless you cannot meet the margin call).

 

2) If I no longer want to own the option, I sell it.  You seem to arbitrarily hold options until Wed/Thur of expiration week.  That is terribly foolish.  The ideal time to sell an option is when YOU no longer want to own it – not on an arbitrary calendar date.

 

3) The price paid for the option is 100% irrelevant.  I don't know why so many people get hung up on this.  Assume you own a call option and the price is $6.  Assume you no longer believe the stock is moving higher.  Does the price paid for that option change the decision to sell?  Would you sell if the cost were $2 but hold if you paid $7?  If 'yes,' then you don't understand trading. 

 

When you no longer want to own a position then don't own it.  Do not hold just because it would result in a loss if you were to sell.  You already lost the money, and holding invites a larger loss.

 

Bottom line: You either want to exercise your option, or you don't.  You either want to sell your option, or you don't.  The price you paid is ancient history and 100% immaterial.

 

4) If the time value is negligible, then there is no theta to be 'eroding fast.'  Theta is the erosion of time value.

 

5) I would never change my mind.  Period.  Exercising a call option is stupid (exceptions noted above).  Just take that as gospel.  It is stupid.  Just sell it when you don't want to own it.  Interest rates do not matter over a two-day period.  But why own stock for two days?  Don't exercise.

 

6) If the option bid is less than parity (i.e. if you cannot get at least a fair price for the option), then it is possible to exercise and IMMEDIATELY sell stock.  But this involves extra commissions and is probably still a bad idea.

 

It is NOT the bid/ask spread that matters.  If the stock is 60 bid, you can sell stock at 60.  If you own the 50-call and the market is 10 bid 14 asked, what difference does that make to you if the market is wide.  If you can sell at 10, that is easier and less expensive than selling stock.

 

If however, the market is 9.90 to 10.10, that's a nice tight market, but does you no good.  You want to sell the call at $10.  So yes, in this example, you may exercise and immediately sell stock.

 

Exercising calls to own the shares is a trade made by someone who should not be trading options.  One more point – if you were to make the mistake of exercising early, why would you do it in the morning?  Wait until the close of trading.  It is possible that the stock will decline 20 points that day and you would be left holding the bag.  Exercise instructions are irrevocable.

 

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