Call options allow the buyer to purchase stock at a specified price over a specified time.  However, there are two types of call options, one known as American style and the other known as European style. 

An American style option allows the buyer to exercise early while the European counterpart requires the buyer to wait until option expiration before purchasing stock with the call option.  The question now is this: Is it ever advantageous to exercise an American style call option early; that is, prior to expiration?

The answer will be very obvious to you once we go through some analogies, but surprisingly, this is one of the most common sources of option errors.

If you trade options, be sure you understand this section, as it will keep you from making one of the costliest mistakes in option trading.

Exercising early

Let's start with the answer and then we will show why it is true:

It is never optimal to exercise a call option early except to capture a dividend.

There are many ways to show this is true.  Unfortunately, most of the methods involve fairly complicated methods comparing two different portfolios of stocks and options,then comparing them after early exercise to see if one portfolio has an advantage over the other.  I don't particularly like these methods as proofs for most investors, as they can get complicated, but we will show you one of these methods at the end anyway.  For now, let's show why you should never exercise a call option early (except to capture a dividend) by using a simple story.

Say your broker calls you one day with a hot deal.  He has 1,000 shares of ABC stock that he must get rid of.  The stock has moved up sharply over the past couple of weeks, from $30 to the current price of $75.  He tells you, "This is the hottest stock on the market and is certain to move higher.  If you buy it now, I will not charge you a commission."

You think it doesn't sound like such a bad deal.  You have been hearing about the company in the news lately and were thinking of buying shares anyway.  You tell your broker, "I do not like to make these kinds of decisions in such a short time.  I'd really like to research the stock to see exactly what this company does."

Because you have been a customer of the brokerage firm for so long, the broker makes you this final offer.  "I will give you 10 days to research the stock and, if you decide that you want to buy it, I will reserve the shares for you at the current price of $75.  If, after 10 days, you decide you do not want them, just let me know and I will not charge you anything."

On your first day of research, you come to the conclusion that this company will be bigger than Microsoft and Intel combined.  You will be wealthy beyond your wildest dreams if you could just purchase this stock.  You must have the shares! 

Now, here's the question: Do you call your broker after the first day and buy the shares?  Remember that he has given you 10 days to make up your mind and will reserve the $75 price for you.

Hopefully you realize the answer -- you wait until the tenth day.  Why?  There are two reasons.  One, because the brokerage firm is holding the stock and they are the ones at risk!  If the stock falls, you will just tell your broker you don't want the shares at $75, as you will just purchase them in the market yourself.

Second, as with any payment, you should prefer to pay as late as possible so that you can earn interest on your money in the meantime. Your purchase price will be $75,000 regardless of whether you buy today or on the tenth day.  The answer is clear; you wait as long as possible and call your broker on the tenth day to purchase the stock.

This example may seem blatantly obvious -- almost absurd -- as to the correct answer.  But don't laugh; many advanced option traders make this mistake every single day.  The situation we just described above is a call option and many traders, mistakenly, elect to call the shares away early.

How is it a call option?  Think about what your rights are with a call.  You have the right, but not the obligation, to purchase stock for a fixed price over a specified time frame.  In the example above, you had the right with no obligation to purchase the shares for $75 for a period of ten days.  The reason the example seemed absurd is because you were not required to pay any fees for the privilege of locking in the $75 price. 

In fact, if your broker required you to pay a fee, you would exactly have a call option (technically it would be called a forward agreement since the "call option" was not purchased as a standardized contract).

Why traders feel they must exercise early

Traders who exercise early make the mistake of not realizing exactly what is happening in a call option agreement.  Often, this is how they view the situation.  Say the trader purchases a $100 call option for $15.  The stock is now $130 with over a month left of time.  The option is trading for $32.  Here is the mistake: The trader often feels he does not want to "lose" the value of the call option.  So, before the market gets the best of him, he decides to exercise it and walk away the winner.  Wrong!  Remember that the trader is locked into the price of $100.  The stock can be trading for $200 and have split twice by expiration, and the stock price is still $100 to the owner of the call option.  If he exercises early, however, the stock could completely collapse and he would have been better off not exercising.  Also, by not exercising early, the $100 stays in the money market longer to earn more interest.

So what should you do if you feel your option is really high in value and you want to get out before it falls?  Sell the call to close.  Why?  In this example, the trader exercised early and received stock worth $130, but paid only $100 for a gain of $30.  After subtracting the cost of the call, $15, his net gain is $15.  But if he sold the call to close in the market, he would receive $32 for a net gain of $17 after subtracting out the $15 cost.  In other words, if you exercise your call option, you will only receive the stock in exchange for the strike price; you receive only the intrinsic amount.  If you sell the call to close, you will collect the intrinsic amount plus the time premium.  You will always be better off selling the call to close if you do not want to continue holding the call option. 

The last thing you want to hold is the stock; that is the reason you buy the call option in the first place!

Still not convinced?

If you are still not sure whether or not that you should exercise a call option early, think about this scenario.  Say a trader has a covered call position and bought stock at $100 per share and sold a 1-year $100 call for $25.  Now, if they get assigned, they will lose the stock but make a 33% profit (effectively buying the stock for $75 and selling it for $100 a year later).  An investor who enters this trade considers the 33% profit a good deal, based on the risk of the stock, for one year's time.

Now, think about this, what is the best thing that could happen to this trader?  The best thing would be for him to check his account the next day and see the stock called away.  Now he has received 33% in a day instead of a year, which is a much better return (too big to print!).  Well, if it's a better deal for the short call position to be called early, it must be an equally bad deal for the long call.  This is because options are a zero-sum game; that is, the one trader's gains are exactly the other trader's losses.

Because the long call has control, that investor will do what is best for him -- he will wait until the very end of the year to exercise the call and receive the stock.

Mathematical models

It was mentioned at the beginning that we would look at a mathematical model in addition to the simplistic proofs covered so far.  Here, we will look at one of many mathematical proofs that show it is never optimal to exercise a call option early on a non-dividend paying stock. 

Consider two portfolios, A and B.

Portfolio A:  Present value of exercise price in cash + call option

Portfolio B:  Stock

At expiration, the cash will grow to be worth E, the exercise price.  Portfolio A will use this cash to secure the exercise price.  If the stock is above the strike price and Portfolio A exercises the call, the investor will receive the value of the stock price minus the exercise price (S - E) plus E from the cash which can be written: S - E + E = S.  So, if Portfolio A exercises at expiration, Portfolio A is worth the stock price -- exactly as Portfolio B, which contains only the stock.

However, if the stock price falls below the exercise price, E, at expiration, then Portfolio A will lose the value of the call and only be worth E, the cash.  Portfolio B will be worth less than Portfolio A because the stock price is below the exercise price. 

So, Portfolio A is always worth at least as much as Portfolio B. 

But if Portfolio A exercises early, the portfolio is worth S minus E (from the exercise) minus the present value of E, which must be less than S.  Why?  Because you are subtracting off E and then adding back a number a little smaller than E (because it's the present value).  Now, this is the only time Portfolio B can dominate Portfolio A, so A should not exercise early.

I told you I don't like these proofs and now you probably see why!

If you read our section on synthetics during week 11, you will recognize that Portfolio A is really a synthetic call option.  By exercising early, Portfolio A gives up the protective value of the put.  So no matter which method you use, it is never optimal to exercise a call option on a non-dividend paying stock early.

Capturing a dividend

We have been saying to never exercise a call option early except to capture a dividend.  Why would an investor want to do that?  There are a couple of reasons.  One, the stock may have announced a huge, special dividend.  As a call option owner, you are not entitled to anything other than the price appreciation in the stock above the strike price.  If the dividend is large enough, you may find it beneficial to exercise the call early in order to be the owner of the actual stock and therefore be entitled to the dividend.  In this case, the investor should wait as long as possible and exercise the call the day before ex-dividend date.

The second reason that investors will exercise the call option early is to reduce a loss due to a dividend.  Say a stock is trading at $100 and will pay a $1 dollar dividend tomorrow.  A trader bought a $95 call a while back for $10, and it is now trading for $5 plus a little time premium.  The option will expire in a relatively short time.

However, the stock will be trading for $99 tomorrow morning ex-dividend (the price of the stock is reduced to reflect the dividend payment from the company).  What will happen to the call?  It will trade for $4 because the stock is down $1, so the trader may elect to exercise the call early to reduce the loss. 

So exercising early to capture a known dividend is really a loss reduction strategy as opposed to a profit-seeking one.

One exception for margin traders

Here is a great tip you will not see in any books or hear from brokers.  Say you trade on margin (borrowed funds) and are holding a very deep-in-the-money call, maybe a $30 call with the stock trading for $100.  Assume there is some time left on the option; it could be a few days or even months. 

If you exercise early, you will meet the Fed call for the stock just by exercising!  This is because the call is so deep-in-the-money.  Because you are receiving stock so highly valued relative to the strike, your margin cash available and buying power will explode to the upside.  So if you are in a situation where you need to generate cash available or buying power to take advantage of a certain stock, or perhaps to meet a margin call, exercising early may be your answer!

The reason you never see this in the textbooks is because, by itself, exercising early gains you nothing in the asset.  It is only due to other market mechanics of margin trading where it may benefit you.  So, keep that in the back of your mind if you ever are lucky enough to have a call option go very deep-in-the-money and need to trade on margin.  You should definitely check with your broker for specific details.

Early exercise with puts

Early exercise with puts, unlike calls, may be advantageous to the long position.  This is because put options represent a cash inflow to your account.  If the put option is very deep-in-the-money (technically where delta is equal to one), the put should be exercised.  As an example, assume you are holding a $100 put option with 3 months of time remaining.  The stock is trading at $40 and you see no hopes of it coming back above $100 by expiration.  If you wait until expiration, you will receive $100 for your stock.  If you exercise now, you will receive $100 for your stock.  Which do you prefer?  As with any cash inflow, we prefer to have it paid earlier as opposed to later, so we exercise the put and take our $100 now.

Although options can be used as a tool to buy or sell stock, most option contracts, somewhere in the neighborhood of 98%, never become exercised.  This is because most option traders use them as a hedge.  For example if an option trader has 100 shares of stock at $50 and also has a $50 put.  The stock closes at $40.  Rather than using the put to sell the stock, the option trader will close out the put for a $10 gain and use that to offset the $10 loss in the long position.  Because of this fact, most option traders are not very familiar with exercising options.  Make sure you become very aware with when and why to exercise. Not understanding can be costly.