When it makes sense to Early-Exercise a position

I just made-up the following example for demonstrating an Early Exercise of a LongCall position.
Let me know if you spot an error in the calcs.

Bought 1 Call DTE=60 Strike=5 when underlying stock S=5.00 (ie. ATM) and Call Bid=0.40 Ask=0.50
(ie. PremiumPaid=0.50 plus Commission=0.65)
After 10 days the underlying stock has risen to S=6.00, and Call Bid=0.30 Ask=0.40
You think the stock won't rise any more.
Should you do an Early-Exercise or just let it Auto-Exercise at expiration?

IMO Early-Exercise makes sense, as you would have made a ROI of 8.83% in just 10 days:
ROI = (100 * 6 + 0 - 100 * (0.50 + 5) - 0.65 - 0.65) / (100 * (0.50 + 5) + 0.65 + 0.65) * 100 = 8.833600%
Annualized (365d) ROI: 2097.09%
Monthly (30d) ROI: 28.91%

Of course you need to have the necessary cash (100 * 5 = 500) available to be able to exercise the position.
And: of course immediately after receiving the stocks you should sell them for >= $6 , which is very well possible as the stock price is $6.

Waiting till expiration is non-optimal, as then the Annualized (and Monthly) results would be less (due to taking-up more time (ie. "time is money")).


And the following is the ROI example in the above linked wikipedia article:

 

It never makes sense to exercise an option early if there is any extrinsic value left in the option. If you want a stock position, you would be better off selling the option and then trading the stock (which you can do as a spread). You will end up with the same position as exercising, but will have captured the options extrinsic value, which you lose by exercising.

 

Hmm. interesting. Can you quantify how much your method would be better over the other method by using the said quotes?
I tend to believe that it sometimes very well makes sense to exercise early, though haven't studied it deeply yet.
This thing, if understood well, could in fact mean an "edge"

 

Be rest assured that any edge only exists in your mind ..

Yeah,look at the div vs carry and the corresponding put,but that's another bedtime story,which I have already read to you..

An option is worth more alive than dead barring divs and possible hard to borrow situations..

 

Can't remember. Do you have a link?

Hmm. it depends, I would say, b/c timing is all...
Sometimes it makes sense to close earlier, for example when the max possible profit (when ShortSelling) was reached much earlier. As said, then "time is money" applies...

 

Closing a position earlier and exercising early are two different things.

You talked about exercising early which never makes sense when there is extrinsic value in an option.

There are very few situations where you would exercise early.

For a call (as @taowave mentioned)
Just before an ex dividend when the dividend is higher than the corresponding put and any cost of carry. In this case there will be no extrinsic value in the call

In certain cases where the stock is hard to borrow

For a put, when the cost of the corresponding call is lower than the cost of carry of the short stock position. (short stock and long call will equal the former long put position)

It is possible you may also exercise early, in a deep option with no extrinsic value, when you find the liquidity in the stock is better than the liquidity in the option. You would trade the stock and exercise the option if you wanted to close a position.

 

I said closing b/c the latter example was about ShortSelling.

 

As @FSU, it almost never makes sense to exercise early if there's extrinsic value in the Call. If the spreads are wide and you can't get it sold at a fair price then exercise.
If a stock if 6 and the 5 Call is 1.10, why exercise if you can sell the Call for 1.10 then buy the stock for 6? Save yourself the .10 ($10)(minus commissions).

The numbers in your example aren't logical.
If the stock is 6 the bid/ask on the 5 Call is going to be 1.0 or higher.

 

Yes, B/A for S=6 is buggy; a better numbers would be say about Bid=1.1 Ask=1.20.
Selling for 1.10 by closing early would make $0.05 more than when exercising early.
Means the early closing would bring $5 more than early-exercising.
So, yes, in that case an early-exercise is sub-optimal over an early-close.
But this still does not answer the question whether it's better to keeping it till the expiration date.
IMO in this case an early-close or early-expire is better than keeping it till expiry.
The annualized result will show it.

 

Typo: early-expire --> early-exercise.

Btw, right now I'm writing some code for comparing all the 3 cases.