Definition and Examples of American Options
Comparison Between American and European Options
Advantages and Disadvantages of American Options
What Does It Mean for Individual Investors
Definition and Examples of American Options
An American option is a type of options contract that grants the investor the ability to exercise the contract at any time until the expiration date. The American option allows the investor the right to exercise the contract at any time from the purchase date of the contract until the expiration date of the contract.
Note: Options grant the holder the right, but not the obligation, to exercise the contract at a predetermined strike price. They may choose to let it expire if exercising the option is not profitable.
An American call option means buying the underlying stock at the strike price. An American put option means selling the underlying stock at the strike price.
For example, you can buy one call option for XYZ stock at 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 allow you to buy stocks at the strike price, so if the price of XYZ rises above $50 at any time between January 1 and June 1, you have the option to exercise the contract and buy the stock at a price lower than its market value and sell it for a profit.
Early Exercise Risks
The risk of American options is that the option may be exercised early, resulting in lost potential profits.
For American call options, this can occur if the stock price rises after the option is exercised. For example, if the price of XYZ rises to $51, you might exercise the option and make a small profit. If the price later rises to $60, you might have made more if you had waited to exercise the option.
Note: Generally, it is not advisable to exercise American call options for stocks that do not pay dividends. There may be some merit in early exercise to obtain a stock that pays dividends.
American Option vs. European Option
The main difference between American options and European options lies in the holder’s right to exercise the contract.
American Option European Option
Exercisable at any time before expiration Exercisable only on expiration date
Greater flexibility generally means they are worth more and carry a higher premium than European options Less flexibility generally means they are worth less and carry a lower premium than American options
American options are typically traded on exchanges European options are typically traded in the over-the-counter (OTC) market
The ability to exercise the option before the expiration date makes American options more flexible than European options. If the underlying security is volatile, it is possible that at some point between the purchase date and the expiration date, exercising the option may be profitable, even if it would not be profitable to exercise it on the expiration date. This makes American options more valuable than European options, which means American options require higher premiums compared to European options.
Note: On the other hand, European options are more predictable. The option seller does not have to worry about early exercise of the option. The option holder also does not have to spend much time tracking the option’s value and deciding whether to exercise it or not.
Advantages and Disadvantages of American Options
Advantages:
– Greater flexibility for option holders
– Traded on exchanges rather than over-the-counter
Disadvantages:
– Less predictability for option sellers
– Option holders may miss out on potential profit opportunities
What Does It Mean for Individual Investors
Individual investors should consider the type of option they are buying or selling. Option holders typically prefer buying American options because they provide more flexibility. If you are selling American options, be aware that the option can be exercised at any time before the contract expiration date. You should be prepared to fulfill the contract if the option holder chooses to exercise it early.
Taking
American options can be exercised at any time before the expiration date. American options are usually more valuable and carry higher premiums than non-flexible options. Option holders must monitor the price of the underlying security throughout the period of holding the contract. Option sellers should be prepared to exercise the contract if the option holder chooses to exercise it early.
Summary:
– American options can be exercised at any time before the expiration date
– American options are more valuable and carry higher premiums than non-flexible options
– Option holders must monitor the price of the underlying security throughout the period of holding the contract
– Option sellers should be prepared to exercise the contract if the option holder chooses to exercise it early
Source: https://www.thebalancemoney.com/american-option-5196305
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