An American option, also known as an American-style option, is a variant of an options contract that grants holders the flexibility to exercise their option privileges at any point up to and including the expiration date. This stands in contrast to the European option, which permits execution solely on the expiration date.
The American-style option empowers investors to seize profits promptly when the stock price shifts advantageously, and it also facilitates capitalizing on dividend declarations.
American-style options operate by granting the holder the flexibility to exercise their entitlement at any point prior to the contract’s maturity date. In contrast, European option contracts can only be executed on the day of maturity. The majority of securities traded on exchanges today adhere to the American option model. These contracts are defined by a minimum of four key variables:
Underlying asset. This encompasses common and preferred stock, commodities, interest rates, and derivatives.
Premium. The cost paid during the purchase or sale of an option.
Strike price. The value at which the contract holder holds the right to either sell (put option) or buy (call option) the underlying asset.
Maturity date. Also known as the expiry date, the option loses its value if not exercised on this specific date.
There are two variants of American options based on the rights they confer to their holders:
Call option, representing a long position, permits the investor to purchase the underlying asset at a pre-established price (known as the strike price) before or on the expiration date.
Put option, embodying a short position, grants investors the ability to vend the underlying asset at the strike price at any point leading up to the option’s expiration.
The capacity to acquire or sell securities at a predetermined price holds significant value for investors, as it empowers them to capitalize on fluctuations in the underlying asset’s value.
Specifically, when the stock price rises, call options allow investors to procure securities at a price lower than the prevailing market rate. Conversely, triggering a put option in times of declining underlying asset prices enables investors to sell securities at a price higher than the prevailing market rate. In both scenarios, investors realize profits.
Advantages of American Options
Flexibility in Exercise. Investors benefit from the liberty to execute the option at their convenience, even if the asset’s price exceeds the strike price before the expiration date.
Pre-Ex-Dividend Exercise. The option to exercise prior to the ex-dividend date permits holders to own the underlying stocks and qualify for dividends in the subsequent period.
Optimized Profit Utilization. American options enable investors to reinvest profits swiftly, promoting more active engagement in the market.
Disadvantages of American Options
Higher Premium. American-style options entail a greater upfront cost, factoring in the premium, which affects the overall profitability of the trade.
Unavailable for Index Option Contracts. American options are not accessible for index option contracts, limiting their application in certain investment scenarios.
Potential Missed Appreciation. There’s a possibility of forgoing additional option appreciation if the decision is made to exercise the option before its expiration date.
In March, an investor acquires an American-style call option for Apple Inc. (AAPL) with an expiration date at the end of December of the same year. The premium for the option contract is $5, and each contract represents 100 shares ($5 x 100 = $500). The option’s strike price is $100. As the stock price climbs to $150 per share:
The investor exercises the call option on Apple prior to its expiration, procuring 100 AAPL shares at the $100 strike price. Effectively, the investor holds 100 AAPL shares at the predetermined price. The investor promptly sells these shares at the current market rate of $150 per share, yielding a profit of $50 per share.
In total, the investor earns $5,000 in profit, deducting the initial premium of $500 paid for the option and any associated broker commissions.
Assuming an investor anticipates a decrease in the value of shares of Meta Inc. (META), they purchase an American-style July put option in January. This option matures in September of the same year. The premium for the option contract amounts to $3, and each contract represents 100 shares ($3 x 100 = $300). The strike price for the option is $150. As Meta’s stock price declines to $90 per share:
The investor exercises the put option, resulting in a short position of 100 META shares at the $150 strike price. This translates to the investor buying 100 META shares at the current price of $90 and then selling them at the $150 strike price. The net difference is settled, and the investor realizes a profit of $60 per option contract.
Ultimately, the investor earns $6,000 in profit, factoring in the initial premium of $300 paid for the option, along with any broker commissions.
Consider a scenario where an investor anticipates a forthcoming decline in the value of Microsoft Corporation stocks. To capitalize on this projection, the investor acquires an American put option with a $100 strike price, despite MSFT stock’s current market value of $110.
The investor incurs a cost of $5 per share as a premium for the put option, thus investing a total of $500 for 100 shares.
Over time, the value of MSFT shares drops to $70 each, enabling the investor to trigger the put option and vend their shares at the predetermined $100 strike price. This transaction yields a gain of $30 per share, amounting to a cumulative profit of $3,000 for all 100 shares.
After subtracting the $500 paid as premium for the put option, the investor’s net profit from the Microsoft Corporation stocks’ downturn reaches $2,500.
Nevertheless, if the investor’s projections fail to materialize and the value of MSFT stocks rises rather than falls, the investor refrains from exercising the option and absorbs the loss of the $500 invested in the premium.
To mitigate the risk of total losses, the investor must take proactive measures and salvage some value before the option’s expiry date approaches. One strategy involves attempting to sell the option in the secondary market at a reduced premium, thereby offsetting losses and exiting the trade.
Frequently, holders of American-style options opt not to engage in early exercise due to the prevailing cost-effectiveness of either retaining the contract until maturity or exiting the position by selling the option outright. To clarify, the call option’s value and premium follow suit as the stock price ascends. Traders can offload an option back to the options market if the present premium exceeds the initial premium paid during initiation. The trader’s profit would amount to the difference between these two premiums, factoring in any applicable fees or broker commissions.
However, specific situations prompt early option exercise. Deep-in-the-money call options are typically exercised early when the asset’s price significantly surpasses the option’s strike price. Similarly, puts can be deep-in-the-money when the price substantially falls below the strike price. Generally, "deep" denotes an amount exceeding $10 beyond the in-the-money threshold. For equities of lower value, "deep-in-the-money" might entail a $5 margin between the strike price and the market price.
Another instance of early execution arises before a stock goes ex-dividend—this marks the deadline for shareholders to possess the stock and receive the next scheduled dividend payment. Since option holders do not partake in dividends, many investors exercise their options before the ex-dividend date. This allows them to seize the profits from a favorable position and secure the dividend payment.
Dominance of American Options. Exchange-traded options linked to stocks are primarily of the American Options variety.
Dividend Eligibility. Stockholders are qualified to receive dividend payments if they hold shares before the ex-dividend date. This date marks the point at which stockholders become eligible for dividends in the upcoming period. Notably, option holders do not partake in dividend payments.
Timely Exercise of American Options. American options are frequently exercised prior to the ex-dividend date. This practice enables option holders to own the underlying stocks and qualify for the forthcoming dividend distribution.
Optimal Profit Potential. American Options grant the holder the right to exercise the option when the security or stock promises maximum profitability for the holder.
Impact of Stock Price Increase. When the stock price experiences an ascent, the value of a call option follows suit, resulting in an escalation of the associated premium.
Strategic Option Selling. An option holder has the option to sell the American option back to the market. If the current premium surpasses the premium initially paid upon entering the contract, the option holder can reap benefits from the discrepancy between the premiums.
American-style options are traded on various options exchanges, both physical and electronic, across financial markets. These exchanges provide a platform for investors to buy and sell American-style options contracts on a wide range of underlying assets, including stocks, indices, commodities, and more. Notable options exchanges such as the Chicago Board Options Exchange (CBOE), NYSE Arca Options, and Nasdaq Options Market facilitate the trading of American-style options, offering investors the opportunity to capitalize on market movements and exercise their rights before the option’s expiration date.
The distinction between American and European options lies primarily in their exercise characteristics, which significantly affect their trading and timing. American options grant their holders the flexibility to exercise the option at any point before or on the expiration date, allowing for strategic decisions based on market movements. On the other hand, European options solely permit exercise at the moment of expiration, depriving holders of the ability to seize opportunities that arise before the predetermined expiration date.
Most individual stocks and exchange-traded funds (ETFs) utilize American-style options, enabling investors to exercise them prior to their expiration dates. Conversely, several broad-based equity indices, such as the S&P 500, exclusively employ European-style options, restricting exercise to the exact expiration date. These options cease trading one day earlier, concluding on the close of business on the Thursday preceding the third Friday of the expiration month.
With American-style options, investors can strategize and take advantage of evolving market conditions. For instance, when a stock’s price is favorable, call option values increase, influencing the premium. Investors can choose to sell their options back to the market if the present premium surpasses the initial cost, potentially yielding a profit from the difference. However, European-style options introduce complexity in determining the settlement price, which affects their exercise. This settlement price is calculated based on underlying stock prices at the opening of the expiration day, making it less straightforward compared to the regular closing price utilized in American-style options.
Yes, an American option typically commands a higher premium compared to a European option. This pricing discrepancy arises from the fact that an American option provides the holder with the privilege to exercise the contract at any juncture between entering into the contract and the expiration date. This added flexibility entails a premium cost premium, reflecting the potential for early exercise. In contrast, a European option confines exercise to the specific expiration date, resulting in a comparatively lower premium due to its more restricted exercise window.
American options are priced using various complex mathematical models, with the most common being the Black-Scholes model and its extensions. These models take into account factors such as the current stock price, strike price, time to expiration, volatility of the underlying asset, risk-free interest rates, and dividend yields. The key difference between pricing American options compared to European options lies in the early exercise feature of American options. This added dimension makes pricing American options more intricate, often requiring the use of numerical methods like the Binomial model or advanced computational techniques. Traders and investors use these pricing models to assess the fair value of American options, helping them make informed decisions about buying, selling, or hedging these derivative instruments.
One of the primary risks associated with American options is the potential loss of the premium paid by the option holder. Since American options typically come with a higher premium compared to European options due to their early exercise feature, the option holder faces the risk of losing this upfront cost if they choose not to exercise the option before its expiration. Moreover, the flexibility to exercise the option at any time can lead to decision-making challenges, as timing the exercise becomes crucial to capitalize on price movements effectively. Additionally, the complex nature of early exercise introduces uncertainties and risks related to the potential opportunity cost of exercising too early or too late. These factors necessitate careful risk management strategies for traders and investors engaging with American options.
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