Early Exercise Rules for Short American Options in Backtests

Summary

The document asks how a backtest should model early exercise when short an American option. It contrasts using an arbitrary threshold for exercise with treating the contract like a European option, then describes exercise considerations that depend on option type and dividends.

The response says an American call on a non-dividend-paying stock is generally not exercised early because selling retains time value. For a dividend-paying stock, early exercise may be preferable when the dividend benefit exceeds the option’s remaining time value. An American put has an optimal exercise boundary tied to the underlying price and remaining payoff; the response notes that locating this boundary can be difficult and model-dependent. These are broad principles rather than a complete simulation algorithm, and the document does not specify a pricing model, discrete exercise procedure, or market conventions.

Key ideas

• An American call without dividends is generally not exercised before expiration because it retains time value.
• For a dividend-paying call, exercise can be attractive when the dividend benefit exceeds remaining time value.
• An American put’s early exercise depends on an optimal boundary for the underlying price.
• Backtests need an explicit exercise model, and put exercise boundaries may require assumptions.

Tags

# Methodology for handling short american options in a back test


# Methodology for handling short american options in a back test












Given that an American option can be exercised at any time, how does one handle algorithmically shorting an American option in a back test? I am not sure what the best practice is to simulate the early exercise for selling American Options in a backtest.

There are two approaches I can think of:

- Assume that the option gets exercised if it crosses an arbitrary percent in the money.

- Treat the option the same way you would handle a European option.

## Answer by emcor (score 1, accepted)

https://quant.stackexchange.com/a/18331

An American Call without dividends is never exercised before maturity, because it is always better to sell it instead. With dividends, one would exercise if the value of future dividends is higher than the time value (from selling the Call).

An American put without dividends is exercised when $S$ hits an optimal exercise boundary (e.g. if $S=0$ one would always exercise because the maximum payoff is reached). Finding the optimal exercise boundary for an AM put is however still an open question, some researches assume an explicit functional and fit it to the model.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.