Exercising an American option before expiration; rational only when the remaining extrinsic value is worth less than what exercising captures.
Exercising throws away all remaining extrinsic-value. So it is only rational when something else is worth more: a dividend about to be paid to shareholders for a call, or the interest on strike proceeds for a deep in-the-money put.
That gives a simple rule for sellers. Check the extrinsic value on your short leg. If it is close to zero and a dividend is imminent, assume you will be assigned and decide now whether you want the resulting position.
Example: XYZ at $58, ex-dividend $0.60 tomorrow, and the $50 call has $0.08 of extrinsic value. A holder who exercises gives up $0.08 to collect $0.60. They will exercise, and the seller ends up short 100 shares plus the dividend obligation.
Original diagrams for the ideas on this page. Illustrative, not real market data.
Buying a call: payoff at expiry. A 105-strike call bought for 3 loses that whole 3 if the price finishes at or below 105, breaks even at 108, then gains a dollar for every dollar higher. The loss is capped at the premium; the upside is not capped.Time decay of an option's value. The part of an option's price that is only time — its extrinsic value — drains away every day and must reach zero at expiry. The slide is gentle months out and steepest in the final weeks, which is what traders call theta.
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