What are American Options?
An American Option is a type of options contract (Call or Put) that can be exercised at any time at the will of the holder of the option 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 is favorable. A European option is the exact opposite of an American Option wherein the option holder cannot sell the option until the day of expiration, even when it is favorable. There is no geographical connection in relation to the names since it only refers to the execution of the options trade.
Types of American Options
There are two types of American Options.
#1 – American Call Option
An American Call option allows the holder of the option the right 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. In an American Call option, the strike price does not change throughout the contract.
If the holder of the option does not want to exercise the option, he/she may choose not to exercise the option since there is no obligation to receive the security or stock. American call options are usually exercised when they are deep in the money, which means the asset’s price is very 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..
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.
#2 – American Put Option
An American Put option allows the holder of the option the right to ask the buyer of the security of the stock anytime between the execution date and the expiration date when the price of the asset falls below the strike price.
If the holder of the option does not want to exercise the option, he/she may choose not to exercise the option 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 very much lower than the strike price.
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 is trading 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.
Advantages of American Options
- The biggest advantage of American options is the ability to exercise the contract at any time before the expiration date.
- The ability to exercise the contract before the ex-dividend date, which enables the option holder to own the stocks and be eligible for dividend payment for the next period.
- It facilitates the profits to be optimally utilized and promotes increased market activity.
Disadvantages of American Options
- An American option is expensive when 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 he/she decides 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.
- Exchange-traded options on stocks are majorly American Options.
- An option holder is not eligible for dividend payments. Stockholders before the ex-dividend date are eligible for dividend payments. The ex-dividend date is the date by which stockholders become eligible to receive dividends for the next period.
- American options are usually exercised prior to the ex-dividend date since it allows the option holder to own the stocks and be eligible for the next dividend payment.
- American 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.
- When the stock price rises, the value of a call option increases, and so does the premium that is charged.
- An option holder can also consider selling the American option back to the market if the current premium in the market is higher than the premium, which was paid at the time of entering into the contract. In this case, the option holder will benefit from the difference between the two premiums.
- The time at which option can be exercised determines the type of option. If the option can be exercised any time before the expiration date, it is an American Option.
- 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.
- An American option allows the option holder to reap maximum benefits since it allows exercising the contract when the security or stock is favorable for the option holder.
This has been a guide to What is American Option and its definition. Here we discuss the two types of American options (call & put options) along with examples, advantages, and disadvantages. You can learn more about excel modeling from the following articles –