What are American Options?
American Options are a type of options contract that can be exercised at any time at the will of the holder of the option on or before the expiration date. It allows the option holder to reap benefits out of the security or stock at any time when the security or stock movement is favorable.
American options are exact opposites of European options wherein the option holder cannot sell the option until the day of expiration, even when it is favorable. There is no geographical connection between the names since it only refers to executing the options trade.
Table of contents
- An American option is a contract granting the holder the right to exercise it before its expiration. It provides the flexibility to capitalize on security or stock at its most advantageous moment.
- European options follow distinct rules. Unlike the European option, the American-style option cannot be sold before expiration. Notably, these names lack any geographic significance.
- The American options category includes the American call and put options. This variety empowers holders to maximize potential gains by allowing them to execute the contract when the security or stock aligns with their preferences.
American Options Explained
American options are flexible options contracts, offering investors the right to exercise a call or put as and when the stock price movement seems favorable. This contract allows them to buy or sell securities on or before their expiration date. This flexibility lets investors choose the best time to exercise the contract, depending on the profits that the change in the prices of the stocks from time to time offer.
These options contract also help investors to make the most out of the dividend announcements that different companies make. Within the contract, the timeframe for exercising the contract is specified, which indicates when the investors can take a call. These contracts, given the liberty that they provide to investors, involve added premium payment and hence are expensive.
Exchange-traded options on stocks are majorly American-styled options. Stockholders before the ex-dividend date are eligible for dividend payments. The ex-dividend date is the date by which stockholdersStockholdersA stockholder is a person, company, or institution who owns one or more shares of a company. They are the company's owners, but their liability is limited to the value of their shares. become eligible to receive dividends for the next period. An option holder is not eligible for dividend payments.
American options are usually exercised before the ex-dividend dateEx-dividend DateAn ex-dividend date is one of the four important dividend dates, usually set one business day before the record date. It is a deadline; shareholders need to buy the stocks before this date to become eligible for the upcoming dividend payout. It is also called the ex-date. since it allows the option holder to own the stocks and be eligible for the next dividend payment.
These options give the right to the option holder to exercise the option at the time when the security or stock is most profitable for the option holder.
It is a style of options contract that enables the holder of the options to exercise the contract at any time before the expiration date. Based on the nature of calls the investors take depending on the movement of the stocks, there are two types of American-styled options.
#1 – American Call Option
An American Call option allows the holder of the option to ask for the delivery of the security or stock anytime between the execution date and the expiration date when the price of the assets shoots above the strike price. The strike price does not change throughout the contract in an American Call option.
If the holder of the option does not want to exercise it, they may choose not to exercise it since there is no obligation to receive the security or stock. American call options are usually exercised when they are deep in the money, meaning the asset’s price is much higher than the strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market..
#2 – American Put Option
An American Put optionPut OptionPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated. allows the holder of the option to ask the buyer for the security of the stock anytime between the execution date and the expiration date when the asset price falls below the strike price.
If the holder of the option does not want to exercise it, they may choose not to exercise it since there is no obligation to sell the security or stock. An American Put option can be deep in the money when the asset’s price is much lower than the strike price.
Though American-styled options allow holders to exercise deals at any time within the life of the contract, they prefer holding the instrument until expiration. In addition, they may also look forward to exiting positions and selling the contract immediately. To know how to price American options, which ultimately determines the action the holders would take, it is important to know how the price movement occurs and in what manner it affects the price movements in the market.
The rise in the prices of the stock leads to an increase in the call option value. Likewise, the premium related to the contract also increases. In case, the current premium is more than the initial premium that traders pay in the beginning, they sell the instrument back to the options market. The difference between the premiums, when subtracted becomes the trader’s gross earnings. When the broker’s charges are subtracted from that difference, it becomes the net earnings of the trader.
Let us consider the following examples and understand American options trading in a more detailed manner:
Example 1 – American Call Option
ABC Inc has been doing good business for the past two quarters, and you are convinced that the stock price will go above the current market price of $150 per share. The contract consists of 100 shares.
Strike = $160
Premium = $10/share
Toal Premium = $10 x 100 = $1,000
The stock does well, and the price goes to $180; in this case, you will exercise the option and buy the stocks at $160 per share and sell it at $180 per share in the market.
Profit = (Selling Price of the Stock – Option Exercise Price) – Premium
= ($180 x 100) – ($160 x 100) – $1,000
= $(18,000-16,000) – $1,000
Entering the option contract was a good decision, and exiting the contract at the right time was even better. This is an American Call Option.
Example 2 – American Put Option
ABC Inc has been in the news for internal issues in its management, and you assume that the stock price will go down in the current month. You can buy a put option to make money out of this situation. The stock trades at $150 per share, and the contract size is 100 shares.
Strike = $140
Premium = $10
= $10 x 100
The company plunges to $120; the good news, isn’t it? You buy the shares from the market at $120 and exercise your option at $140 per share.
Profit = (Option Exercise Price – Buying Price of the Stock) – Premium
= ($140 x 100) – ($120 x 100) – $1,000
= ($14,000 – $ 12,000) – $1,000
It is important to exercise the call or put option at the right time in an American option.
American Options give investors the flexibility of exercising the contracts based on their favorability. This is one of the major reasons that make these options one of the most sought-after in the trading sector.
Below is a list of the merits of exercising American options for maximum profits:
- The biggest advantage of American options is the ability to exercise the contract anytime before the expiration date.
- The ability to exercise the contract before the ex-dividend date enables the option holder to own the stocks and be eligible for dividend payments for the next period.
- It facilitates the profits to be optimally utilized and promotes increased market activity.
When an American-styled option offers flexibility, it becomes quite obvious for it to be available at a cost or fee. Investors who are willing to exercise American options have to pay more premiums.
Besides this, there are other disadvantages as well, which must be known to the investors.
- An American option is expensive compared to a European option since it charges a higher premium for the luxury of exercising the options at any time before the expiration date.
- The option holder might lose out on a potential higher appreciation if they decide to exercise the option contractOption ContractAn option contract provides the option holder the right to buy or sell the underlying asset on a specific date at a prespecified price. In contrast, the seller or writer of the option has no choice but obligated to deliver or buy the underlying asset if the option is exercised. before the expiration date.
Frequently Asked Questions (FAQs)
American options hold greater value due to their unique feature of allowing exercise at any time before expiration. This flexibility empowers investors to capitalize on favorable market movements at multiple points, potentially leading to higher profits. However, this benefit comes with a premium, making American options generally costlier than their European counterparts, which only permit exercise at expiration.
European options and American options are both derivatives granting the right to buy or sell an underlying asset at a predetermined price before or at expiration. However, the key distinction lies in exercise timing. European options can only be exercised at maturity, while American options grant the holder the flexibility to exercise at any point before expiration. This feature influences pricing, with American options typically carrying a higher premium due to their enhanced flexibility.
American options come with specific risks attributed to their exercise flexibility. The ability to exercise at any time exposes investors to potential market volatility and erratic price fluctuations. This could lead to premature exercise decisions that are suboptimal, resulting in missed profit opportunities or unnecessary losses.
This has been a guide to what are American Options. Here, we explain its pricing details, types, examples, advantages, and disadvantages. You can learn more about excel modeling from the following articles –