An American option is an options contract that gives investors the ability to exercise the contract at any time up to the expiration date. An American option is a highly flexible type of option that lets investors profit from different price movements in securities and add leverage to their portfolios.
This article will cover how they work and how investors can use them.
Definition and Examples of an American Option
An American option is a style of option that gives investors the right to exercise the contract at any time between the day they purchase the contract and the expiration date of the contract.
Options give the contract holder the right, but not the obligation to exercise the contract at a predetermined strike price. They may choose to simply let it expire if exercising the option is not profitable.
For example, you may buy one call option for stock XYZ with a strike price of $50 on January 1. The option expires on June 1. You can choose to exercise the option at any time between January 1 and June 1.
Call options let you buy shares at the strike price, so if the price of XYZ rises above $50 at any point between January 1 and June 1, you have the option to exercise the contract, buy the shares below market value, and sell them for a profit.
Risk of Early Exercise
The risk of an American option is that you may exercise the option too early, losing out on potential profit.
For American call options, that could be the case for a stock where the price goes up after the option is exercised. For example, if the price of XYZ rises to $51, you may exercise the option and earn a small profit. If it later rises to $60, you could have earned more had you waited to exercise the option.
Early exercise of American call options for a non-dividend-paying stock is typically not recommended. There may be some merit to early exercise to get a dividend-paying stock.
An American Option vs. a European Option
The primary difference between American options and European options is in when the option holder has the right to exercise the contract.
|American Option||European Option|
|Exercisable any time before the expiration date||Exercisable only on the expiration date|
|More flexibility means they are generally worth more and command a higher premium than European options||Less flexibility means they are generally worth less and command lower premium than American options|
|Typically, most U.S. stock options are American options||Some U.S. index options are European-style options|
|Typically traded on exchanges||Typically traded in the over-the-counter (OTC market)|
The ability to exercise prior to expiration makes American options far more flexible than European options. If the underlying security is volatile, it’s possible that at some point between the purchase date and expiration date, exercising the option would be profitable, even if it would not be profitable to exercise on the expiration date. This leads to American options being more valuable than European options. This means American options require higher premiums compared to European options.
European options, on the other hand, are more predictable. The option seller doesn’t need to worry about the option being exercised early. The option holder also does not need to spend as much time tracking the value of the option and deciding whether or not to exercise it.
Pros and Cons of an American Option
More flexibility for options holders
Traded on exchanges rather than over-the-counter
Less predictability for options sellers
Options buyers may miss out on potential profits
- More flexibility for options holders: Options holders have more flexibility in when they exercise the contract, which gives them more opportunity to exercise it when stock prices will make exercising profitable.
- Traded on exchanges rather than over-the-counter: American options are widely traded on exchanges rather than over-the-counter, which means the market for American options is larger and more liquid.
- Less predictability for options sellers: Investors who sell American options need to be prepared for the options holder to exercise it before the expiration date, which makes selling these options unpredictable.
- Options buyers may miss out on potential profits: Options holders who exercise the option prior to expiration may find they could have exercised it for greater profit if they’d held the option for longer.
What It Means for Individual Investors
Individual investors need to keep the type of option they’re buying and selling in mind. Options buyers will typically want to buy American options as they offer more flexibility. If you’re selling American options, take note that the option can be exercised at any point before its expiration date. You need to be ready to fulfill the contract in the event the holder chooses to exercise early.
- American options can be exercised at any time up to the expiration date.
- American options tend to be worth more and carry higher premiums than less-flexible options.
- Options buyers have to keep a close eye on the price of the underlying security for the whole period that they own the contract.
- Options sellers must be ready in the event the option holder chooses to exercise the contract early.