American vs European Options option, before, someone, american, exercise

Nishant1

Can someone just explain in others words the reason to exercise an american option before expiration ? And also why there is never a reason to exercise an american call/put early ? Thanks

nitoha

i don't think this is right -- you don't get compensated for time value when you exercise an option. (time value helps determine the cost of the option, but you don't get reimbursed for it when you exercise).

you might exercise an American call option early if the underlying stock is about to pay a dividend that would take your option out of the money (when the stock price drops after going ex-dividend).

you would exercise an American put early if the company was almost bankrupt and its shares were at close to zero -- because you have already made the maximum payoff on your position, there's no point in waiting until expiry to get your profit.

rkapoor

Kia's right....you never exercise an american option (or european option) that isn't in the money.

Also, you may exercise early if you've had a significant move in the underlying position. Let's say the stock you buy a call with a $25 strike is trading at $50 within 2 months of purchase, you say, wow what a move in my favor I didn't think it would go that high, I'm more than happy to sell my shares at $50. So you exercise the stock early, sell at $50 and you're out of the position. A week later it falls back down to $45, by not exercising your option and selling the shares you lost out on $5 in profit.....so the time component in options is a built-in premium, but you also have to consider that it can work against you for positions in the money.

evolsteevol

Options are just bets on the direction of the underlying investment. With an American option, you are allowed to cash out any time. So if your bet is doing well now and you think it might not do so well in the future, you can cash out now and take your profits.

kd26gioi

Thanks Kiakaha...

Micholien

JoeyDVivre Wrote:
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If your
> option is deep in the money you don't exercise
> the option and blow away your time value, you sell
> the option. In the case he gives the stock is
> very volatile (doubling in 2 months) so the time
> value is worth a ton.

Dammit.... It makes so much sense... Thanks Jo
and spreads, for what its worth, I nodded my head at your explanation. I knew you don't exercise early except in cases mentioned by Kiakaha but I used to wonder why coz the scenario you described seemed possible. Now I know why!

marsilni

Joey, please can you come back on this ? "If your option is deep in the money you don't exercise the option and blow away your time value, you sell the option. "
why you don't exercise an option that's is deeply in the money...and how come you sell it ? sorry, i might be slow on this

JoeyDVivre Wrote:
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> spreads gives the classic wrong answer. If your
> option is deep in the money you don't exercise
> the option and blow away your time value, you sell
> the option. In the case he gives the stock is
> very volatile (doubling in 2 months) so the time
> value is worth a ton. spreads - you need to check
> this out and thoroughly understand it.
> Understanding stuff like this is what
> distinguishes CFA charter holders from joe
> bago'donuts financial advisor.

Jolyn

The assymetric payoff of options means that you would still gain more from favorable price movements than you would lose from adverse movements even if you're already deep in the money.

pacmandefense

so is it just to say that it's better to wait a little bit more if you expect a favorable fluctuation in the price of the underlying, even if your option is already deeply in the money ?

Then that works more for call options where the potential gain is unlimited right ?

amqata

Miss*Yiota Wrote:
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> Joey, please can you come back on this ? "If your
> option is deep in the money you don't exercise
> the option and blow away your time value, you sell
> the option. "
> why you don't exercise an option that's is deeply
> in the money...and how come you sell it ? sorry, i
> might be slow on this
>
>
I can tell you what I understood... Say you are long on a call at 25.. the stock's current price is 50 so intrinsic value of the option is 50-25 = 25. There is also a time value which is quite high since the option is extremely volatile. It could go even more up very quickly so someone will pay you $25 + time value to buy it. If you want to get rid of the option because you expect it to go down, you should sell it, not exercise it... you may get, say $45 where $20 is the time value of the option when you sell the option. If you exercise it, all you will get is $25.



Edited 1 time(s). Last edit at Tuesday, May 10, 2011 at 11:39AM by anish.