American Option Definition, Pros, Cons, and Examples
A variation of an options contract known as an American option, also known as an American-style option, enables holders to exercise the option rights at any moment up to the day of expiry. In contrast, the European option, a different option, only permits execution on the day of expiration.
With an American-style option, investors may profit as soon as the stock price changes in their favor and can also benefit from dividend announcements.
How to Use American Options
American options specify the window of opportunity for the option holder to execute their contractual rights. These rights allow the owner to purchase or sell the underlying asset at the established strike price on or before the option’s predefined expiration date, depending on whether the option is a call or a put. American-style options are more lucrative than constrained European options since investors can exercise them anytime throughout the contract’s lifespan. The chance to exercise early does come with an additional premium or expense, though.
The Friday of the week the option contract expires is often the last day to execute a weekly American option. In contrast, the third Friday of the month is often the final day to exercise a monthly American option.
American options dominate exchange-traded options on individual equities, whereas European options on indices are more common.
Call and Put American Options
A long call option provides the right to demand delivery of the underlying security or stock on any day throughout the contract period. Both the day before and the day of expiration are included in this feature. As with all options, the buyer is not compelled to receive the shares or exercise their entitlement. Throughout the contract, the strike price has the same stated value.
An investor could execute a call option they bought for a firm in March with an expiration date of the end of December of the same year at any time up to that date.
Additionally, American put options permit execution until the expiration date. When the price drops below the designated strike price, the buyer can freely demand the seller deliver the underlying asset.
The opportunity cost of not investing the put option gains or the cost of carry are two factors that contributed to the early exercise. Investors are paid the strike price right away when a put is exercised. As a result, the money raised can generate income by investing in another asset.
However, since executing puts would result in the sale of the shares, the investor would lose out on any dividends. Additionally, if the option is retained until expiration, its value may rise further, meaning exercising it early may result in losing out on potential earnings.
When to Work Out Early
The early exercise feature is frequently not used by holders of American-style options since it is frequently more economical to retain the contract until it expires or to sell the option contract outright to close the position. In other words, if the price of a stock rises, a call option’s value and premium also do. If the current premium exceeds the initial premium paid initially, traders may sell an option back to the options market. The net difference between the two premiums, less broker costs or charges, would be paid to the trader.
Options are sometimes frequently exercised early, though. Call options that are deeply in the money, or where the asset’s price is much higher than the option’s strike price, are typically executed early. When the price is far below the strike price, puts can also be deep in the money. High prices often refer to more than $10 in the money. Deep-in-the-money might be defined as a $5 difference between the strike and market prices for lower-priced stocks.
Early execution can also occur before a stock’s ex-dividend date, the deadline by which shareholders must own the shares to be eligible for the next dividend payment. Dividend payments are not made to option holders. Many investors will exercise their options before the ex-dividend date to realize the gains from a profitable investment and get the dividend.
Benefits and Drawbacks of American Options
American options are advantageous since investors can exercise the option immediately once the asset’s price climbs over the strike price. The upfront cost of American-style options, which investors must pay, must be considered when calculating the trade’s total profitability.
- Allows for any time exercising
- permits exercise before a dividend exclusion date.
- allows for the reinvestment of earnings
Cons Increases the premium.
- Not accessible for contracts using index options
- Miss out on potential future option appreciation
Illustrations of American Options
Imagine that a shareholder bought a call option in the American style with an expiration date of the end of December of the same year for Apple Inc. (AAPL). One option contract costs $5 and has a $100 strike price. One option contract equals 100 shares ($5 x 100 = $500). The stock price increased to $150 per share after the transaction.
Before the call option on Apple expires, the investor buys 100 shares of Apple for $100 each. In other words, the investor would be long 100 Apple shares at the strike price of $100. The investor instantly sells the shares for the $150 market price and keeps the $50 profit per share. The total return to the investor was $5,000 after deducting any broker commissions and the $500 fee for purchasing the option.
Consider a scenario in which a shareholder predicts a drop in the value of Meta Inc. (META), previously Facebook, over the following months. The investor buys a July put option in American form in January that expires in September of the same year. The option’s strike price is $150, and the option premium is $3 per contract (100 x $3 = $300).
The investor executes the put option and sells 100 shares of Meta at the $150 strike price when the stock price of Meta drops to $90 a share. The investor essentially purchases 100 shares of Meta at $90 and sells them right away at the $150 strike price. In reality, the investor makes a $60 profit on the option contract, which is equal to $6,000 minus the $300 premium and any broker charges, and the net difference is resolved.
- A type of options contract known as an “American option” enables holders to exercise their rights at any time, including the expiration date.
- Investors can make money with an American-style option as soon as the stock price changes in their favor.
- In the United States, options are frequently exercised before the ex-dividend date, enabling investors to possess shares and receive the next dividend payout.