There are two type of options according to exercise rights; European style exercise, which is only at expiration and is the exercise right for some stock index options and the VIX versus American style exercise, which can be done any time up to expiration. When done before expiration day it is known as early exercise. There are a few situations when a premium seller is at risk of early exercise. What are those situations and how should a trader react?
While early exercise can happen at any time, it is highly unlikely to happen outside of a few situations. An option that is deep in-the-money (ITM) is one possibility. Should the option have little or no extrinsic value left, exercising the option may make sense for the buyer. Early exercise is also a possibility in an ITM option in which the underlying pays a dividend and the amount of the dividend is greater than the extrinsic value in the option. Some graphics were shown to aid the understanding of this. Should the bid price of the short option be less than the intrinsic value there is a real chance of early exercise.
A list of what traders can do if they are assigned early was displayed. The list included buying a Covered Call or selling a Covered Put to reinitiate a position in the same options cycle, closing out the position completely and rolling out in time. Brokerage firms will allow traders to close positions on the day they experience early exercise even if they would not have the buying power.
For more information on Exercise & Dividend Risk see:
Options Jive from June 26, 2015: "Early Exercise Risk & Dividend Risk"
Options Jive from October 14, 2015: "How To Gauge Early Assignment Risk"
Options Jive from January 26, 2016: "Indicators of Early Assignment Risk"
Watch this segment of Options Jive with Tom Sosnoff and Tony Battista for the key takeaways and a full understanding of early exercise risk and how to react should it occur.
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