When does it make sense to exercise equity options early? Does it happen frequently? In the September 2015 version of their paper entitled “Early Option Exercise: Never Say Never”, Mads Jensen and Lasse Pedersen investigate the interaction of investment frictions (shorting, trading and funding costs) and early exercise of equity options. They estimate shorting frictions via daily cost-of-borrow rankings for underlying stocks. They estimate trading frictions via option bid-ask spread rankings. They estimate funding friction as cost of required margins in excess of the risk-free (Federal Funds) rate. Using groomed data for U.S. equity options along with associated stock prices and borrowing cost data spanning 2003 through 2010, they find that:
- Over the sample period, market participants exercise early 1.8 billion option contracts on stocks that pay no dividend. Early exercise is more likely when:
- Shorting costs for the underlying stocks are high. Among options for stocks with the highest (lowest) shorting costs, 4.3% (0.2%) are exercised early.
- The option is costly to trade. The fraction of options exercised early increases systematically with option bid-ask spread.
- The option is deeper in-the-money. Among deep in-the-money options on stocks with the highest shorting costs, 8.4% are exercised early.
- The option is close to expiration. Among options within three months to expiration on stocks with the highest shorting costs, 7.6% are exercised early.
- Both market makers (perhaps driven by hedging/shorting costs) and customers of brokers (perhaps driven by trading costs) initiate early exercises.
- A model incorporating shorting, trading and funding costs explains as much as 98% (67%) of early option exercises by market makers (broker customers). Results suggest that market makers are more cost-sensitive, or more attentive to costs, than are their counterparties. Some of the largest unexplained early exercises relate to corporate events.
In summary, evidence indicates that investment frictions sometimes drive decisions regarding early exercise of U.S. equity options (and may thereby affect strategies that trade in-the-money equity options with an assumption of holding to maturity).
Cautions regarding findings include:
- The sample is somewhat stale, and findings may be influenced by the unusual 2008-2009 financial crisis.
- The study does not address potential effects of early option exercise on in-the-money option strategies.
