by Mike Scanlin

Early exercise for a call option is when an option holder exercises his purchase right prior to the option's expiration date. Normally an option holder would not do this; he would just wait until expiration day and then decide if he wants to exercise or not. However, there are some cases where taking early exercise is the optimal decision.

The Call Option Buyer's Rights

Buying a call option means the purchaser has the right, but not the obligation, to buy 100 shares of stock at the strike price any time between today and when the option expires. The buyer does not need to give a reason for exercising his option, he just informs his broker he'd like to do it.

The Call Option Seller's Obligations

When the Options Clearing Corp receives an exercise notice from the option holder's broker, they randomly assign the notice among all of the people who have short contracts outstanding (that's why some people may be assigned and others may not be assigned -- the assignment is random). If the option seller is given an assignment notice then he is obligated to deliver the shares in exchange for cash equal to the strike price per share.

Reasons For Early Exercise

The most common reason for early exercise is when the underlying stock is about to pay a dividend. Call option holders do not receive dividends, but stock holders do. In addition, the day the stock goes ex-dividend the underlying stock price will be reduced by the amount of the dividend, thus reducing the value of the call option. So, some call option holders will exercise the day before the ex-dividend date in order to get the dividend.

The downside of early exercise for the option holder is that they forfeit any time premium remaining in the option. If they want out of their long call option position while it still has time premium then they are better off just selling their option instead of exercising it.

Does Early Exercise Matter For Covered Call Investors?

Normally, having stock called away is a result that covered call investors look forward to. It means they have achieved the best possible outcome. To get this result sooner than the expiration day is considered a good thing.

The only time an investor may not want early exercise has to do with taxes. Having your shares called away is the same (for tax purposes) as selling your shares. That sale could generate an unwanted tax event (realized gain or realized loss) if the shares are held in a taxable account. Early exercise in a non-taxable account, like an IRA, is no big deal -- if the investor still wants to own the shares he can just go buy replacement shares.

How To Protect Against Early Exercise

First of all, the option you sold has to be in-the-money. It would be silly for the holder to take early exercise on any option that wasn't in-the-money.

Second, if you don't want your shares called away then a couple of days before each ex-dividend date you should check the amount of time premium remaining in the option you've sold (for a discussion on how to calculate time premium, please see the Covered Call Tutorial). If an in-the-money option has only a few pennies (or less) of time premium then you may want to buy those options back and sell new ones that have more time premium in them, since most rational investors will not do early exercise if there is still a decent amount of time premium left in the option.

What About Stocks That Don't Pay Dividends?

It is very unlikely (read: it would be financially irrational) that an option holder would take early exercise on a non-dividend paying stock. Again, they will forfeit any remaining time premium so they would be better off just selling their call option instead of exercising it.

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Mike Scanlin is the founder of Born To Sell and has been writing covered calls for a long time.