The Early Exercise of American Puts
Let us suppose there are no
dividends. Suppose you hold an American put and the stock goes bankrupt,
meaning that the stock price goes to zero. You are holding an option to sell it
for X dollars. There is no reason to wait until expiration to exercise it and obtain your X dollars. You might as well
exercise it now. Thus, bankruptcy is one obvious situation in which an
American put would be exercised early. However, bankruptcy is not required to justify early exercise. If the stock price
falls to a critical level - and thus cannot fall much further - an
American option might be exercised early and
the funds reinvested.
If the
stock pays dividends, it might still be worthwhile to exercise it early, but because dividends drive the stock price down, they may make
American puts less likely to be exercised early. In fact, if the dividends are sufficiently large,
it can sometimes be shown that the put would
never be exercised early, thus making it effectively a European
put.
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