Let's Work Out Why In-the-Money Puts Won't Get Exercised Early

Many people shy away from selling puts due to fears of early exercise. How would they come up with the cash needed to buy if all their puts got exercised early? Fear of that possibility often leaves them too scared to use the technique. There's very good news for those who they take the trouble to fully understand how options work: Out-of-the-money options will never be exercised, and, contrary to what many expect, even in-the-money put options rarely get exercised early. Why is that? You have to see things through the eyes of the option owner. The one holding put options always has three choices of what to do with them: They can sit tight, waiting for another time to make a decision. They can exercise the option, or options, if they choose to do so. They can sell-to-close (STC), collecting the present option price and be done with their trade. Which of those choices will be made is almost always predictable by asking one simple question: Which action is in the option owner's best interest? Of course, he'll pick the one with the best possible return. Let's analyze a couple of March 19, 2021 expiration date puts to illustrate this principle. The graphic below shows actual pricing on Michaels $10.00 and $12.50 puts for that date based on its Oct. 12 close at $9.94 per share. How much is it worth to exercise a $10 put with the shares just 6 cents cheaper? The option owner would capture just that few cents, less any exercise expenses (such as a per contract and Securities and Exchange Commission fees). The last trade on those March 19, 2021 $10 puts, though, was still $2.40. Exercising right now would obviously be the worst choice. The proper choice, based on the owner's best interest, would be either sitting tight and hoping for a big decline in MIK, or selling the option to recoup whatever premium was still available by selling to close. Here's a quick cheat sheet on the three choices: Capture 6-cents a share via exercise. Receive $2.40 per share ($240 per contract) by STC and be done with the option trade. Hold on, risking up to $2.40 per share while hoping for more. Only doors No. 2 and No. 3 make any sense at all (thank you, Monte Hall). Now let's examine the same scenarios, using the deeper in the money $12.50 puts. Here are those same three choices based on the prices listed in my graphic. Capture $2.56 in in-the-money value (less expenses) via immediate exercise. Receive $4.10 per share ($410 per contract) by STC. Hold on, risking up to $4.10 per share while hoping for more. Once again, immediate exercise is clearly the worst choice for the option owner. An option holder who, wanting to exit the position would sell to close. Someone still bearish on MIK would hold on, praying for a large decline before expiration day. The more time premium still availing for selling the option, the safer the option writer is relating to the very slim chance that someone will exercise early. Selling LEAP options (those with extra-long expiration dates) out to 2022 and 2023 significantly lowers the chances of being exercised any time soon. It also brings in the highest amount of money up front. Anyone paying for one to three years of time is not going to waste that asset by using it in the short run. There you have it. You only have to worry about early exercise if your short put is deep-in-the-money, and that particular option has virtually no time premium. That typically only occurs with very illiquid strike prices and expiration dates with not much time left prior to expiration. If that situation occurs, you could consider rolling out your puts. I'll cover that technique in a later article. The key takeaway: Option owners are almost 100% sure to do what is in their best interest, not yours. That protects you from early exercise in the vast majority of situations.

Let's Work Out Why In-the-Money Puts Won't Get Exercised Early

You must first consider the goal of the option owners, who are sure to do what is in their best interest, not yours.

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