Early exercise works specifically with options contracts and it is only possible with American-style options.
An option contract is a financial derivative that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified time frame.
Types of Options
- Call Option: In call option, the holder has the right to buy the underlying asset at a specified price before the expiration date.
- Put Option: This gives the holder the right to sell the underlying asset at a specified price before the expiration date.
The benefit of early exercise
Early exercise allows options holders to realize profits or limit losses before the expiration date, which can be advantageous if market conditions change.
The risk of early exercise
Early exercise also carries the risk of giving up potential profits if the underlying asset’s value continues to increase (for call options) or decrease (for put options) after the exercise.
Examples of Early Exercise
Example 1: A call options holder exercises their right to buy a stock at a strike price of $50 per share, even though the current market price is $60 per share. By exercising early, the holder can purchase the stock at a discounted price and realize a profit.
Example 2: A put options holder exercises their right to sell a stock at a strike price of $100 per share, even though the current market price is $90 per share. By exercising early, the holder can sell the stock at a higher price and limit their losses.
Early Exercise vs Late Exercise
Early exercise occurs before the expiration date, while late exercise occurs on or after the expiration date.
The decision to early or late exercise depends on various factors such as the options holder’s objectives, market conditions, and the options’ intrinsic value.
Key point
Early exercise can be a useful tool for options holders to realize profits or limit losses before the expiration date. However, it also carries risks that must be carefully considered before making a decision.
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