Confusion about options: can one exercise at any time?

Question

I am at the beginning of learning about options. I am reading a book on the subject. I am in a chapter about selling covered calls. The book says:

Defensive covered call writers may prefer the in-the-money strike price because it provides more premium up front. On the other hand, the stock will be called away if it's still in the money at expiration.

My (limited, newbie) understanding is that one can exercise the option at any time before the expiration. So that, in the case the book references, the call buyer might prefer to exercise the option as soon as it's in the money, and not wait until expiration (when it might be out of the money).

What am I missing?

Answer 1

Options that trade in the U.S. are either American (stocks and ETFs) or European (most indexes) style. The owner of an American style option may exercise it at any time during the life of the contract. A European style option can only be exercised at expiration.

Exercise before expiration isn't very common. Per 2017 stats from the Option Clearing Corporation (OCC), only 7% of options were exercised. About 70% were closed before expiration and the remaining 23% expired worthless. The primary reason why one would sell the option to close is because if there is any time premium remaining, it would be thrown away by exercising. Secondly, exercise involves additional commissions and more B/A slippage.

IMHO, selling defensive in-the-money covered calls isn't the best idea. If you're defensive, get out of the position. Secondly, for writing in-the-money, there are IRS "Qualified Covered Call" rules which can affect the holding period and hence the taxation of the position.

Answer 2

the call buyer might prefer to exercise the option as soon as it's in the money, and not wait until expiration (when it might be out of the money).

Not really. Suppose you have an american option to buy a non-dividend-paying stock at $50 that expires in one month. The stock is currently trading at $45. True, you could exercise now and pocket an easy $5, but the option itself is worth more than $5 (because of time value, a different discussion), so selling it would be a better option. On top of that, suppose you exercise but don't sell the stock. If the stock gains, you've profited (but the option would have been worth more as well). If the stock drops below $50, you've LOST your $5 profit and more, while if you still held the option your loss would have been capped at $5.

As Bob mentions, it's very rare that exercising early is the best move for an option holder. The only cases I know of involve dividends, special tax treatment, or other edge cases. in the "normal" case either selling to close or holding until expiry are better choices.