An American option, also known as an American-style option, is a versatile version of an options contract that allows holders to exercise their option rights at any time before and including the expiration date. This flexibility differentiates it from European options, which only allow execution on the expiration date.
American-style options enable investors to capture profit as soon as the stock price moves favorably and take advantage of dividend announcements.
Key Takeaways
- An American option allows holders to exercise their rights at any time before and including the expiration date.
- Investors can capture profit as soon as the stock price moves favorably.
- American options can be exercised before an ex-dividend date, allowing investors to qualify for the next dividend payment.
Exploring the Mechanism of American Options
American options outline when the option holder can exercise their option contract rights. These rights allow the holder to buy or sell—depending on if the option is a call or put—the underlying asset, at the set strike price on or before the predetermined expiration date. Due to this flexibility, American-style options are generally more valuable than European options. However, this added advantage usually comes with an increased premium or cost.
For weekly American options, the last day to exercise is normally the Friday of the expiration week, while for monthly options, it’s typically the third Friday of the month. Most exchange-traded options for single stocks are American, whereas options on indexes are generally European. The terms ‘American’ and ‘European’ are about the style of options execution and not the geographic location.
American Call and Put Options
A long call option gives the holder the right to demand delivery of the underlying security or stock any day within the contract period, including the day of expiration. The buyer is under no obligation to receive the shares and can choose whether to exercise their right based on the strike price.
Example of American Call Option:
Suppose an investor purchased a call option for a company like Apple Inc. in March with an expiration date at the end of December of the same year. The investor exercises the call option any time before the expiration date at the agreed strike price, regardless of the price movements of the stock during that period. This ability ensures the investor can capitalize on price movements and market conditions dynamically.
Likewise, American put options allow execution at any time up to and including the expiration date. This option allows the buyer to demand the seller to take delivery of the underlying asset whenever the price falls below the specified strike price. Early execution could be due to factors like the cost of carry or investing gains from a put option elsewhere.
Example of American Put Option:
If an investor purchased a put option on Meta Inc. in January with a July expiration, and the stock price falls significantly, the investor can exercise the put before the expiration date. This flexibility allows the investor to make informed, strategic decisions based on market dynamics.
When to Exercise Early
It’s often more cost-effective for holders of American-style options to hold the contract until expiration or to exit the position by selling the option outright. As the stock price rises, the value and premium of a call option increase. Traders can sell the option back to the market, if the current premium is higher than what they initially paid, thus earning a net difference.
Early exercise commonly occurs with deep-in-the-money options. These are characterized by significant movements of the asset’s price above or below the option’s strike price. For call options, if a stock’s market price far exceeds the option’s strike price, it often leads to early exercise. Similarly, put options that are significantly below the strike price are exercised early.
Another typical scenario for early exercise involves an approaching ex-dividend date. To receive dividend payments, some investors may choose to exercise their options pre-ex-dividend, securing gains from their position and qualifying for the upcoming dividend.
Advantages and Disadvantages of American Options
Here’s a snapshot of the pros and cons of American options to help you understand their full impact on your trading strategy:
Advantages:
- Flexibility to exercise at any time
- Ability to exercise before an ex-dividend date
- Opportunity to re-invest profits immediately
Disadvantages:
- Higher premium charges
- Not available for index option contracts
- Potential loss of additional option appreciation
Real-Life Examples of American Options
Example 1: Apple Inc. Call Option
An investor buys an American-style call option for Apple Inc. in March, expiring at the end of December. The premium is $5 per contract—since one contract consists of 100 shares, this amounts to $500. The strike price is $100. As the stock price rises to $150, the investor exercises the call option, buying 100 shares at $100 each, then selling them in the market at the current price of $150. The profit is $50 per share, totaling $5,000 minus the premium and any broker commission.
Example 2: Meta Inc. Put Option
An investor foresees a decline in Meta Inc. shares and buys an American-style put option in January, expiring in July. The premium is $3 per contract, amounting to $300 for 100 shares. The strike price is $150. If the stock price drops to $90, the investor exercises the put option. They effectively buy shares at $90 each and sell at the $150 strike price, settling the net difference for a profit of $60 per share, equating to $6,000 minus the premium and broker commissions.
Related Terms: European options, expiration date, options premium, cost of carry, exchange-traded options.
References
- The Options Industry Council. “Options Expiration Calendar”.
