The investing term American option refers to contracts that give the investor the right to buy or sell a security at a specific price on or before a certain date. An American call option provides the investor with the right to purchase a security, while a put option provides the investor with the right to sell it.
How Do American Style Options Work?
An American option allows the holder to exercise their right at any time prior to the contract's maturity date, while European option contract can only be exercised on the maturity date. Most securities traded on an exchange today are American options. These contracts will specify at least four variables:
Underlying asset – Common and preferred stock, commodities, interest rates, as well as derivatives;
Premium – The price paid when an option is purchased or sold;
Strike price – The price at which the holder of the contract has a right to sell (put option) or buy (call option) the underlying asset;
Maturity date – Also referred to as the expiry date, the option no longer has any value if not exercised on this date.
American Style Option Types
By the option rights they provide their holders, there are two types of American options:
Call, or a long position, that allows the investor to buy the underlying asset at a predetermined price, known as the strike price, before or on the expiration date.
Put, or a short position, which provides investors with the opportunity to sell the underlying asset at the strike price, at any time leading up to its expiration.
Having the ability to buy or sell securities at a predetermined price can be very valuable for investors as it allows them to take advantage of price movements in the underlying asset.
Namely, exercising call options when the stock price rises enables investors to buy securities at a lower-than-market price. On the other hand, activating a put option when the price of the underlying asset drops, allows the investor to sell securities at a higher-than-market price. In both cases, the investor turns a profit.
Suppose that an investor expects the price of Microsoft Corporation stocks to will decline in the foreseeable future. To capitalize on their expectation, the investor buys an American put option with a strike price of $100, even though the MSFT stock currently trades at $110.
Our investor pays a premium of $5 per share for the put option and invests a total of $500 for 100 shares.
After some time, the price of MSFT stocks decreases to $70 per share, allowing the investor to activate their put option, and sell their shares at the strike price of $100. This deal with bring them a profit of $30 per share, or a total profit of $3,000 for all 100 shares.
After deducting the $500 paid as premiums for the put option, the investor's net profit from the decline in Microsoft Corporation stocks would be $2,500.
However, if the investor’s expectations were not met, and the price of MSFT stocks increased, instead of decreasing, the investor would not activate the option and lose the $500 they invested in the premium.
To avoid complete losses, the investor has to take action and salvage some value before the option's expiry date arrives. They can try to sell the option at the secondary market at a lower premium, offset their losses, and exit the trade.
American Options Pros and Cons
- Can be activated at any time before their expiration
- Provide flexibility in position management
- Potential to capture additional gains from ex-dividends
- More profitable than European style options when exercised correctly
- More costly premiums than European options
- Risk of missing out on further appreciation by executing early
- Impose a high degree of unpredictability
- Increased complexity due to the potential for early exercise
Exercising an American Option Early
Besides selling their nonprofitable options to cut losses, it’s not uncommon for investors to sell options with profitability potential as well. Just like the stock price, the premiums of American options also fluctuate as a response to market conditions.
Some investors are happy to sell their potentially profitable options for a higher premium than initially bought and profit from the difference between the two prices. Other investors prefer to hold on to them until expiration. However, in a specific situation, commonly known as deep-in-the-money, investors choose to execute their option rights early.
As a general rule of thumb, investors consider themselves to be in a deep-in-the-money scenario when the strike price is $10 above the market price for calls or $10 below the market price for puts. For some lower-priced equities, a spread of $5 between the strike and market prices can also be considered deep-in-the-money.
Another case where investors may exercise their option right early is when they are in a profitable position, and the underlying stock is about to distribute dividends. Dividends are periodic payments made by a company to its shareholders as a share of its profits. When a stock pays a dividend, there is typically an ex-dividend date set by the issuing company.
By exercising their American call options early and becoming shareholders of the underlying stock before the ex-dividend date, investors become eligible to receive the dividend payment. By timing their activation just right, investors can maximize their gains by capturing additional dividend income and the profits from the options trade.
