American Options

American options are the options that give the holder of the Option the right to retire even before the maturity.

What are American Options?

American options are the options that give the holder of the Option the right to retire before maturity. The issuance of the dividend makes American options more attractive than European options. If the dividend is large enough, the option holder may exercise the Option early. It will probably happen when the dividend amount exceeds the amount of interest forgone due to the early exercise.

An American option, aka an American-style option, is a version of an options contract that allows holders to exercise the option rights at any time before and including the day of expiration. It contrasts with another type of option, called the European option, that only allows execution on the day of expiration.

An American-style option allows investors to capture profit as soon as the stock price moves favorably, and to take advantage of dividend announcements as well.

How American Options Work?

American options outline the timeframe when the option holder can exercise their option contract rights. These rights allow the holder to buy or sell—depending on if the option is a call or put—the underlying asset, at the set strike price on or before the predetermined expiration date. Since investors have the freedom to exercise their options at any point during the life of the contract, American-style options are more valuable than the limited European options. However, the ability to exercise early carries an added premium or cost.

The last day to exercise a weekly American option is normally on the Friday of the week in which the option contract expires. Conversely, the last day to exercise a monthly American option is normally the third Friday of the month.

The majority of exchange-traded options on single stocks are American, while options on indexes tend to be European style.

Types of American Options

American Call Option

An investor can exercise the American Call Option at any time up until the maturity date. This means that the investor must choose the most advantageous moment to exercise the Option. 

American Put Option

A put option in the United States is the polar opposite of a call option. Holders of any option, however, have the choice to exercise it before or on the expiration date. An investor who acquires a put option does not have to wait until the Option expires to exercise it, as is the case with a European option. 

Why are American Options important?

The risk managers choose between the American Options and the European Options as the available options for Hedging. Hence, it is critical to know the concepts of the American Option.

If an investor purchased a call option for a company in March with an expiration date at the end of December of the same year, they would have the right to exercise the call option at any time up until its expiration date.

American put options also allow the execution at any point up to and including the expiration date. This ability gives the buyer the freedom to demand the seller takes delivery of the underlying asset whenever the price falls below the specified strike price.

One reason for 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. When a put is exercised, investors are paid the strike price immediately. As a result, the proceeds can be invested in another security to earn interest.

However, the drawback to exercising puts is that the investor would miss out on any dividends since exercising would sell the shares. Also, the option itself might continue to increase in value if held to expiry, and exercising early might lead to missing out on any further gains.

When to Exercise Early

In many instances, holders of American-style options do not utilize the early exercise provision, since it’s usually more cost-effective to either hold the contract until expiration or exit the position by selling the option contract outright. In other words, 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 if 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.

However, there are times when options are typically exercised early. Deep-in-the-money call options—where the asset’s price is well above the option’s strike price—will usually be exercised early. Puts can also be deep-in-the-money when the price is significantly below the strike price. In most cases, deep prices are those that are more than $10 in-the-money. With lower-priced equities, deep-in-the-money might be characterized as a $5 spread between the strike price and market price.

Early execution can also happen leading up to the date a stock goes ex-dividend—the cutoff date by which shareholders must own the stock to receive the next scheduled dividend payment. Option holders do not receive dividend payments. So, many investors will exercise their options before the ex-dividend date to capture the gains from a profitable position and get paid the dividend.

Advantages and Disadvantages of American Options

American options are helpful since investors don’t have to wait to exercise the option when the asset’s price rises above the strike price. However, American-style options carry a premium—an upfront cost—that investors pay and which must be factored into the overall profitability of the trade.

Pros

• Allows exercise at any time
• Allows exercise before an ex-dividend date
• Allows profits to be put back to work

Cons

• Charges a higher premium
• Not available for index option contracts
• May miss out on additional option appreciation

Difference Between an American Option and a European Option

The basic distinction between the two types of choices is when they can be used. European options can only be exercised at their expiration date, at a single moment in time, but American options can be exercised at any time before their expiration date.

It’s worth noting that, with a few exceptions, American-style options are practically never exercised before expiration in actuality, so the distinction isn’t significant. When the stock price rises after you purchase an option, most people will just sell the option contract to someone else rather than exercising it.