DERIVATIVES R US/V1N5/American vs. European Calls
VOLUME 1, NUMBER 5, March 20, 1995
I ve been noticing an ongoing discussion regarding American vs. European options. In an attempt to hopefully clarify any continued confusion over the effect of early exercise on the prices of these options, I ve decided to tackle the issue in this week s letter. There s only room for covering either calls or puts in one issue so this issue will deal with calls.
Definitions first. A European option can be exercised only at expiration. An American option is a European option with the additional right to exercise it any time prior to expiration. If you ignore transaction costs, taxes, market liquidity and irrationality, then there is no reason to exercise an American call early unless there is a dividend on the stock. The call will never sell for less than the exercise value. If your intuition tells you that a deep in the money call should be exercised because you are worried that the stock will go no higher and might even fall, then are you really going to be any happier having exercised the call? Then you ll just own the stock whose prospects you ve already admitted aren t very good.
The reason the call will always sell for no less than its exercise value is that regardless of how high the stock is, it can always go higher. An exercised call is a dead call and the investor can benefit no further from leveraging the stock price increases nor can he benefit from the downside protection of the call.
If you re still not convinced, consider this example of a call with a strike of $100. Let s say you re at expiration and the stock is worth more than $100. If you had not exercised it early, you would exercise it now, paying $100 and acquiring the stock. If you had exercised it early, you would now be holding the same stock but you paid out the $100 to acquire it at an earlier date and you would be out the interest on $100 from the day you exercised it until today.
In the alternative outcome where the stock is worth less than $100, consider what would happen. If you had not previously exercised it, you would now let it expire. If you had previously exercised it, you would be holding a stock worth whatever its price is today plus you would have forked over $100 earlier and would be out the interest on the $100. If the stock s current price is less than $100, then the stock s current price is definitely less than $100 plus the interest you ve lost.
So in either case, you re worse off having exercised it early. In short, why pay the exercise price early? When you get to expiration you ll be absolutely no better off.
If there are dividends on the stock, it might pay to exercise it early. Exercising it early would leave you in the same position as in my above example, but now you would also have a dividend plus the interest on it, which could be enough to make up the difference. However, you never exercise early to capture the dividend except at the last instant before it goes ex-dividend. Otherwise, you re paying the exercise price out earlier than necessary.
Of course, in practice there may be other reasons for exercising early. Some large institutions with deep in the money calls may choose to exercise early rather than take a large illiquid transaction to the floor where the trade will tell others about their position or result in a decline in the price. Also, the transaction cost of exercising an index option early can be lower than the cost of liquidating the options.
This takes care of calls (I hope). Puts are another question and I ll tackle that one in a future issue. In addition, options on futures are a different story. In that case, calls can justifiably be exercised early. I ll take this one on later as well.
BACK ISSUES: I am getting a number of requests for back issues. Evidently each week there are many new readers who want to get caught up. Unfortunately I am not set up to handle these requests in a simple, low cost manner. Howver, I am currently establishing a filebox into which I will place text versions of back issues for downloading. I will let you know about this as soon as it is available, which will hopefully be any day now.