Introduction
If you yawned when you read the title of this blog post, or wondered if you had mistakenly reached a health & fitness website, you probably are not the first. However, in this case, early exercise does not involve dragging yourself out of bed at dawn to shed a few pounds on the weighing scale.
What is an early exercise in trading?
Instead, early exercise is a stock market strategy specific to futures and options wherein the holder of the put of call contract exercises his or her right to demand purchase or sale of shares at the strike price, prior to the due date or expiration date. By doing this, the contract holder attempts to rake in higher earnings than they would have seen had they waited for the contract due date or expiration date. The goal, therefore, is higher earnings. This is a profitability tactic.
Key concepts in early exercise
Let’s break down some of that jargon/ some of those stock market terms for the beginner traders reading this.
Put options contract – the holder of the contract had the right to demand the purchase of shares at the strike price specified in the contract. However, they are not obligated to sell.
Call options contract – the holder of the contract had the right to demand the sale of shares at the strike price specified in the contract. However, they are not obligated to buy.
ITM, OTM and ATM – In the Money Call Option refers to a situation where the current stock price is higher than the strike price mentioned in the options contract; OTM is the reverse and ATM is when both amounts are equal.
ITM is relevant to our discussion about early exercise.
ITM Put Option refers to a situation where the strike price is higher than the ongoing stock price.
Expiration date – the date specified in the options contract, before which the Put or Call Option has to be exercised.
How it works
Megna had 500 shares of Alliance Power when the pandemic struck India in March 2020. The share price pre-pandemic was Rs 250. Megna was certain that as soon as offices and manufacturing facilities got back on track, the share price of Alliance Power would increase. She wrote a put options contract with a strike price of Rs 300 and a due date of December 22, 2021.
But things are looking fairly on track in October 2021 and as Meghna had predicted, Alliance Power’s share price is on the upswing amidst unlock measures. The share price has now risen to Rs 270.
Megna decides to go for an early exercise. In other words, she decides to exercise her right to sell (as governed by the Put Options contract she holds). Things bode well for her, she decides, because her Put Option is ITM. She sells at Rs 300 even though the current market value is Rs 270, earning Rs 30 per share x 500 shares = Rs 15,000.
Another alternative that Meghna might have in this ITM Put Option situation is to not go for the early exercise, but instead to sell her Put Options contract at a higher rate to traders looking to do an early exercise or to traders looking to buy shares now at Rs 270 and sell the shares at Rs 300 in December 2021. Megna potentially makes some small earnings on the difference between the price for buying and selling the Option (because option prices also fluctuate) and holds on to her 500 shares of Alliance Power, to sell them another day. She might do this to avoid paying Short Term Capital Gains Tax of 15% and instead get to pay Long Term Capital Gains Tax of 10% (which she won’t even have to pay unless her total gains exceed Rs 1 lakh)
Benefits of early exercise
Potential to earn beforehand: If Megna pulls out her investment before the expiration date of December 2021, she effectively makes her earnings in a shorter period.
Potential for incremental/ additional earnings: If Megna reinvests the capital, and the new investment also performs well, she is really scaling up her earnings.
Liquidity: Let’s say Megna experiences a medical or financial emergency while her Put Option is ITM. She need not borrow money or wait till the December 2021 expiration date. She can do an early exercise, sell her shares at Rs 300 and pull out her entire investment.
Considerations of early exercise
Taxes: How long will you have held the investment for if you go for an early exercise. If implementing your early exercise means paying STCG versus either no tax at all or LTCG, you should do the math to see if it actually makes sense to go for an early exercise.
Comparative earnings from selling: Although it is unlikely, do check what your earnings will be if you simply sell the contract to another party. This is especially relevant if you have received some new information that makes you want to hold on to the shares in wait for a steeper uptrend.
Conclusion
Early exercise could be a great way to make your capital work harder for you. It definitely makes sense to opt for it, provided your Put Option is ITM.
That said, the concept of futures and options is fairly complex. If you are a beginner trader you might want to look at less complex profitability tactics. Learn about concepts like PE ratio and the art of buying on dips while you gather stock market experience.
