What are American Options?

Types of American Options

There are two types of American Options.

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#1 – American Call Option

An American Call option allows the holder of the option to ask for the delivery of the security or stock anytime between the execution date and the expiration date when the price of the assets shoots above the strike price. The strike price does not change throughout the contract in an American Call option.

If the holder of the option does not want to exercise it, they may choose not to exercise it since there is no obligation to receive the security or stock. American call options are usually exercised when they are deep in the money, meaning the asset’s price is much higher than the strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more.

Example

ABC Inc has been doing good business for the past two quarters, and you are convinced that the stock price will go above the current market price of $150 per share. The contract consists of 100 shares.

Strike = $160

Premium = $10/share

Toal Premium = $10 x 100 = $1,000

The stock does well, and the price goes to $180; in this case, you will exercise the option and buy the stocks at $160 per share and sell it at $180 per share in the market.

Profit = (Selling Price of the Stock – Option Exercise Price) – Premium

= ($180 x 100) – ($160 x 100) – $1,000

= $(18,000-16,000) – $1,000

=$1,000

Entering the option contract was a good decision, and exiting the contract at the right time was even better. This is an American Call Option.

#2 – American Put Option

An American Put optionPut OptionPut Option is a financial instrument that gives the buyer the right to sell the option anytime before the date of contract expiration at a pre-specified price called strike price. It protects the underlying asset from any downfall of the underlying asset anticipated.read more allows the holder of the option to ask the buyer for the security of the stock anytime between the execution date and the expiration date when the asset price falls below the strike price.

If the holder of the option does not want to exercise it, they may choose not to exercise it since there is no obligation to sell the security or stock. An American Put option can be deep in the money when the asset’s price is much lower than the strike price.

ABC Inc has been in the news for internal issues in its management, and you assume that the stock price will go down in the current month. You can buy a put option to make money out of this situation. The stock trades at $150 per share, and the contract size is 100 shares.

Strike = $140

Premium = $10

= $10 x 100

= $1,000

The company plunges to $120; the good news, isn’t it? You buy the shares from the market at $120 and exercise your option at $140 per share.

Profit = (Option Exercise Price – Buying Price of the Stock) – Premium

= ($140 x 100) – ($120 x 100) – $1,000

= ($14,000 – $ 12,000) – $1,000

It is important to exercise the call or put option at the right time in an American option.

Advantages of American Options

  • The biggest advantage of American options is the ability to exercise the contract anytime before the expiration date.The ability to exercise the contract before the ex-dividend date enables the option holder to own the stocks and be eligible for dividend payments for the next period.It facilitates the profits to be optimally utilized and promotes increased market activity.

Disadvantages of American Options

  • An American option is expensive compared to a European option since it charges a higher premium for the luxury of exercising the options at any time before the expiration date.The option holder might lose out on a potential higher appreciation if they decide to exercise the option contractOption ContractAn option contract provides the option holder the right to buy or sell the underlying asset on a specific date at a prespecified price. In contrast, the seller or writer of the option has no choice but obligated to deliver or buy the underlying asset if the option is exercised.read more before the expiration date.

Important Points

  • Exchange-traded options on stocks are majorly American Options.Stockholders before the ex-dividend date are eligible for dividend payments. The ex-dividend date is the date by which stockholdersStockholdersA stockholder is a person, company, or institution who owns one or more shares of a company. They are the company’s owners, but their liability is limited to the value of their shares.read more become eligible to receive dividends for the next period. An option holder is not eligible for dividend payments.American options are usually exercised before the ex-dividend dateEx-dividend DateAn ex-dividend date is one of the four important dividend dates, usually set one business day before the record date. It is a deadline; shareholders need to buy the stocks before this date to become eligible for the upcoming dividend payout. It is also called the ex-date.read more since it allows the option holder to own the stocks and be eligible for the next dividend payment.American Options give the right to the option holder to exercise the option at the time when the security or stock is most profitable for the option holder.When the stock price rises, the value of a call optionCall OptionA call option is a financial contract that permits but does not obligate a buyer to purchase an underlying asset at a predetermined (strike) price within a specific period (expiration).read more increases, and so does the premium that is charged.An option holder can also consider selling the American option back to the market if the current premium is higher than the premium paid at entering into the contract. In this case, the option holder will benefit from the difference between the premiums.

Conclusion

  • The time at which an option can be exercised determines the type of option. If the option can be exercised any time before the expiration date, it is an American Option.It is a style of options contract that enables the holder of the options to exercise the contract at any time before the expiration date.An American option allows the option holder to reap maximum benefits since it allows exercising the contract when the security or stock is favorable for the option holder.

This has been a guide to What American Option is and its definition. Here we discuss the two types of American options (call & put options), examples, advantages, and disadvantages. You can learn more about excel modeling from the following articles –

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