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Why You Want to Exercise Your Option Before Expiration

Montréal Exchange
April 19, 2021
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Why You Want to Exercise Your Option Before Expiration

Buying an option gives you the right (but not the obligation) to buy and or sell the underlying security. There are a few reasons why an investor would choose to take advantage of exercising his or her options, although it is rarely in the investor’s best interests to do so.

Why Not to Sell Your Option

There are valid reasons why investors would feel the need to sell their options before expiration. But it is perhaps more important to discuss one of the main reasons why you would not want to exercise your option early.

Most notably, the downside potential of owning the underlying stock is much greater compared to the downside potential of holding the option. Consider this example: an investor owns 1 (in the money) ABC Feb 90 call option that cost $800, and the stock is trading at $95.

If the investor exercises the option he or she has essentially bought 100 shares of the stock for $90 a share, or $9,000 in total.

From here there are two scenarios for the stock: it could either go up or down.

First, let us explore what happens if the stock tumbles to $75 in reaction to a very poor earnings report and a slew of downgrades from equity analysts.

The equity position is now worth $7,500. By contrast, had the investor held onto the option, it likely would have expired worthless, resulting in a loss of $800.

If the stock went up from $85 to $95, the call option would have risen in value. At the same time, the investor still has the same right to buy the stock at $90, so exercising it before expiration has had no real financial benefit.

So, Why Would Anyone Exercise Options Early?

There are still valid reasons for an investor to choose to exercise options early.

At the most basic level, a new option investor might get frustrated if he or she does not fully understand what has been bought. It is common for options to move in what seems like erratic and irrational ways.

For example, the price of a call option could fall even when the stock moves higher. In this scenario, an investor might want to simply exit the position, and vow to better understand option pricing dynamics before buying another contract.

Dividend Payment

Investors may also consider selling an option position early if there is an upcoming dividend payment. Option owners are not entitled to the dividend payment, and would need to own the underlying stock prior to the ex-dividend date to receive the dividends.

A special one-time dividend is a unique circumstance where call option holders in particular would want to own the stock instead. They will likely lose some extrinsic value in the call option but potentially collect a lot more cash from a special dividend.

Conclusion: Not Worth It

Exercising an option before expiration is rarely worth it from a purely financial perspective. There might be unique circumstances that warrant exercising the option, but in the majority of cases, it is beneficial to wait as long as possible before exercising an option.

 

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