What Is an American Option?
An American option, otherwise known as an American-style option, is a variant of an options contract that permits holders to exercise the option rights whenever before and including the day of expiration. It diverges from one more type of option, called the European option, that just permits execution upon the arrival of expiration.
An American-style option permits investors to capture profit when the stock price moves well, and to exploit dividend declarations also.
How American Options Work
American options frame the time period when the option holder can exercise their option contract rights. These rights permit the holder to buy or sell — in the event that assuming the option is a call or put — the underlying asset, at the set strike price prior to the foreordained expiration date. Since investors have the freedom to exercise their options anytime during the life of the contract, American-style options are more significant than the limited European options. In any case, the ability to exercise early conveys an additional premium or cost.
The last day to exercise a week after week American option is ordinarily on the Friday of the week in which the option contract expires. On the other hand, the last day to exercise a month to month American option is ordinarily the third Friday of the month.
The majority of exchange-traded options on single stocks are American, while options on indexes will generally be European style.
The names American and European don't have anything to do with the geographic location of the option yet just apply to the style of rights execution.
American Call and Put Options
A long call option gives the holder the right to demand delivery of the underlying security or stock on any day inside the contract period. This feature incorporates any day leading up to and the day of expiration. Similarly as with all options, the buyer doesn't have an obligation to receive the shares and isn't required to exercise their right. The strike price continues as before determined value all through the contract.
In the event that an investor purchased a call option for a company in March with an expiration date toward the finish of December of that very year, they would reserve the privilege to exercise the call option whenever up until its expiration date.
American put options likewise permit the execution anytime up to and including the expiration date. This ability gives the buyer the freedom to demand the seller takes delivery of the underlying asset at whatever point the price falls below the predefined strike price.
One justification behind the early exercise has to do with the cost of carry or the opportunity cost associated with not investing the gains from the put option. At the point when a put is exercised, investors are paid the strike price right away. Thus, the proceeds can be invested in one more security to earn interest.
Nonetheless, the drawback to exercising puts is that the investor would pass up any dividends since exercising would sell the shares. Likewise, the option itself could keep on expanding in value whenever held to expiry, and exercising early could lead to missing out on any further gains.
When to early Exercise
In many occurrences, holders of American-style options don't use the early exercise provision, since it's normally more cost-compelling to either hold the contract until expiration or exit the position by selling the option contract outright. At the end of the day, as a stock price rises, the value of a call option increases, as does its premium. Traders can sell an option back to the options market assuming the current premium is higher than the initial premium paid at the onset. The trader would earn the net difference between the two premiums minus any fees or commissions from the broker.
Notwithstanding, there are times when options are typically exercised early. Deep-in-the-money call options — where the asset's price is well over the option's strike price — will generally be exercised early. Puts can likewise be deep-in-the-cash when the price is altogether below the strike price. Much of the time, deep prices are those that are more than $10 in-the-cash. With lower-priced equities, deep-in-the-cash may be described as a $5 spread between the strike price and market price.
Early execution can likewise happen leading up to the date a stock goes ex-dividend — the cutoff date by which shareholders must possess the stock to receive the next scheduled dividend payment. Option holders don't receive dividend payments. Thus, numerous investors will exercise their options before the ex-dividend date to capture the gains from a profitable position and get compensated the dividend.
Advantages and Disadvantages of American Options
American options are useful since investors don't need to hold on to exercise the option when the asset's price transcends the strike price. Nonetheless, American-style options carry a premium — an upfront cost — that investors pay and which must be calculated into the overall profitability of the trade.
Say an investor purchased an American-style call option for Apple Inc. (AAPL) in March with an expiration date toward the finish of December around the same time. The premium is $5 per option contract — one contract is 100 shares ($5 x 100 = $500) — and the strike price on the option is $100. Following the purchase, the stock price rose to $150 per share.
The investor exercises the call option on Apple before expiration buying 100 shares of Apple for $100 per share. All in all, the investor would be long 100 shares of Apple at the $100 strike price. The investor promptly sells the shares for the current market price of $150 and pockets the $50 per share profit. The investor earned $5,000 in total minus the premium of $500 for buying the option and any broker commission.
Suppose an investor trusts shares of Meta Inc. (META), formerly Facebook, will decline in the forthcoming months. The investor purchases an American-style July put option in January, which expires in September of that very year. The option premium is $3 per contract (100 x $3 = $300) and the strike price is $150.
Meta's stock price tumbles to $90 per share, and the investor exercises the put option and is short 100 shares of Meta at the $150 strike price. The transaction really has the investor buying 100 shares of Meta at the current $90 price and promptly selling those shares at the $150 strike price. Nonetheless, in practice, the net difference is settled, and the investor earns a $60 profit on the option contract, which compares to $6,000 minus the premium of $300 and any broker commissions.
- American options are in many cases exercised before an ex-dividend date permitting investors to claim shares and get the next dividend payment.
- An American-style option permits investors to capture profit when the stock price moves well.
- An American option is a style of options contract that permits holders to exercise their rights whenever before and including the expiration date.