Most options are American-style, meaning that you can exercise them before the expiration date. Early exercise is when you choose to exercise the option before the expiration date. Early exercise has both risks and rewards, and knowing the tax implications can help you make the decision when to exercise your option.

When to Consider Early Exercise

Typically, it makes financial sense to exercise an option early when the option is deep in the money, meaning that the option’s strike price is close to the current market price of the underlying security. If the option is close to expiration and deep in the money, it is likely that the option will expire in the money, and the early exercise can lock in these gains.

Sometimes, an option can become deep in the money due to an unexpected event that causes the underlying security to surge or decline sharply in value, such as a takeover, merger, or other major news announcement. In these situations, early exercise can help you take advantage of the sudden increase in the value of the underlying security.

In addition, employees of startups and companies can also choose to exercise their stock options early to avoid the alternative minimum tax (AMT). When you are able to pay the reduced AMT rate, you benefit by having less taxes than if you kept the stocks until expiration.

Risks of Early Exercise

However, it is important to remember that early exercise involves taking on some risks. In general, the more time remaining on an option until expiration, the greater chance there is that something can go wrong, such as a decline in the stock price, an unexpected market move, or an unfavorable news announcement. By exercising early, you can lock in the gains, but you can also miss out on potential upside.

Also, when an option is close to expiration and deep in the money, the option may still have some time value left, meaning that there is the potential for the option to have additional gains before expiration. If the underlying security increases in value and you choose to early exercise, you can miss out on any potential increase in time value.

Finally, it is important to remember that when you early exercise an option, you are responsible for the transaction costs associated with the purchase or sale of the underlying security.

Tips for Early Exercise

Early exercise can be a valuable strategy to help you take advantage of an unexpected market move or to avoid paying more taxes, but you should always approach it with caution. Before you exercise an option early, consider the risks of early exercise and make sure you understand how it will impact your tax liability. Also, be aware of any fees or costs associated with the transaction. Finally, always remember that there is no one-size-fits-all approach to options trading – make sure to consider your individual objectives, risk tolerance, and financial situation when making decisions about whether or not to early exercise.