Lesson 5 of 6
As we know, unlike a European option, the holder of an American option can exercise the option before the expiry date. Because of this additional benefit of being able to exercise the option early, an American option is always more expensive than a European option. However, is this benefit of any real use, that is, is there a situation where the option holder will get a better payoff by exercising the option early? The answer is NO. You should never early exercise an American option, especially if it’s a non-dividend paying stock. Let’s look at the reasoning behind this.
The option has intrinsic value and time value. The intrinsic value of the option is always greater than 0. Along with that the cash has time value, so you would rather delay paying the strike price by exercising it as late as possible. You could use that money to earn interest.
So, a positive intrinsic value plus time value implies that you are better off selling the option rather than exercising it early. This is true for a non-dividend paying stock.
However, for a dividend paying stock, the only time it may pay to exercise a call option is the day before the stock goes ex-dividend, and only if the dividend minus the cost of carry is less than the corresponding Put. By exercising, the option holder may forego the time value but will make up from the dividend received. We have used the word 'may' because the dividend may not be high enough to justify the early exercise.