American Option Definition - What is American Option?

DailyForex.com Team

An American option is a popular stock option that gives traders greater freedom to exercise option rights. The highly flexible option allows investors to take advantage of the price fluctuations in the market and earn greater profits.

An American-style option is vastly different from a European one. Both have their pros and cons and the ultimate choice of a contract option depends on your trading style and how you wish to navigate the market. Let's take a deeper look at the American option — definition, advantages, examples, and more. 

What is an American Option?

An American option is a type of options contract that allows traders to exercise their option rights at any time till the end of the expiration date of the contract. This option style allows traders to capitalize on the changes in the market to earn profits.

Definition of an American Option

According to an American option contract, a trader can buy or sell an underlying asset at a price at any point up to the end of the expiration date. It offers a flexible time frame for traders to exercise their trading options on a contract. Traders may exercise their rights before or on the expiration date if they find a profitable price. If they don't, they can let the contract expire instead of trading at loss.

American Option vs European Option

While the American option trading allows investors greater flexibility in deciding when to sell or buy an underlying asset in a contract, the European option allows it only on the date of expiration and not before it. The American option is a more flexible and popular alternative. 
There are many elements that separate the American option and European option. Let us take a look at the difference between American option and European option:

 

American Option

European Option

What is it?

A contract option that allows traders to exercise their trading rights at any point till the expiration of the contract.

A contract option that allows traders to exercise their trading rights only on the day of the expiration of the contract.

Who uses it?

It is heavily used. The majority of the options in the market are American.

It is used significantly less compared to the American option, owing to its rigidity.

How is it traded?

It is usually traded over an exchange.

It is usually traded over the counter.

Risk and return

It poses a higher risk as you can trade at any time. That means the return is also higher.

It has a lower risk as the date of the trade is fixed. Thus, the return is also low.

Hedging

Formulating a hedging strategy is a complex process due to the high risk and wider trading window.

You can form a hedging plan rather easily as the date of trade is already known.

Advantages and Disadvantages of the American Option

Though the American option is a popular trading option that grants investors greater flexibility, there are always two sides to every coin. Here is a comparison of the pros and cons of trading with the American option:

Pros

Cons

  • Trade at any time.
  • Poses a high risk.
  • Its flexibility allows for earning more.
  • Is extremely hard to formulate hedge strategies for it.
  • Is traded on exchange rather than over the counter, making it easier to trade.
  • Charges high premium.
  • A more popular and accessible option.
  • Option buyer risks missing out on potential profits.

When and How Investors Exercise the American Option

The American option allows traders a flexible timeframe to exercise their trades. They can buy or sell an underlying asset at any point until the contract expires. This means they can do it whenever they find a profitable price. Many times, traders don’t exercise the option at all as it is a more profitable prospect to hold out the contract until it naturally expires. The premium of the stock increases with its price. The trader can opt to capitalize on the increased value with the American option early exercise.

American Call Option and American Put Option

An American call option gives the holder of the contract the right to demand the delivery of an underlying asset at any point during the life of the contract. This delivery will be done at the agreed price. That being said, there is no obligation on the holder to ask for it, they may do it purely on an optional basis. Similarly, the American put option allows the buyer to demand the seller to take the delivery of the underlying security. This is done when the price of the stock falls below the strike price agreed upon in advance. 

American Option Pricing With Binomial Model

The Binomial Model is an American option pricing formula used to evaluate options by using a generalized numerical approach. It utilized repeated steps over a period of time from the date of the forming of the contract till the expiration of the contract. As the name suggests, there are two outcomes possible at each repetition — either a move up or a move down. The model is based on assumptions of future outcomes based on historic data and is rather simple to use.  However, it can get complex when multiple periods are involved. It is a widely used model that is generally considered more effective than the Black-Scholes. Compared to it, the binomial model allows for a range of possibilities based on a wider even spread of inputs.

Examples of American Option

An investor, for example, buys an American option contract that consists of 10 shares of a company at a premium of $50. The contract ends after 6 months and the strike price is $200. He pays the $500 aggregate premium and observes the price for the next few months. The value of the shares reaches $300 after 5 months. The trader decides to purchase the shares at the agreed-upon strike price of $200 and immediately sells them at the market price of $300. The net difference after excluding the $500 premium equals $1000 for 10 shares.

Alternatively, if the price falls to $100 during the course of the contract, the trader has the option to buy the shares at the market price of $100 and sell them at the agreed-upon strike price of $200. This way, you earn a net difference of $500 after accounting for the premium.

Conclusion

An American option is a popular contract option that allows traders to exercise their trading rights at any point during the life of the contract, right up to the end of the expiration date. A trader may exercise their right early, on the day of the expiration, or simply let the contract expire, enjoying greater flexibility and opportunities to earn big.
A trader must also be wary of the greater risk that comes with the possibility of higher returns. There are various methods available to help you derive an American call option formula and make informed decisions in the market.

FAQs

1.How do you value an American option?

There are various methods to value an American option, the most prominent of them being the Binomial model. It uses repeated steps to derive different values over a period of time to estimate the value of the stock.

2.How are American options settled?

American options may be exercised early, on the date of expiration, or not settled at all. At any point, the price of settlement would be the price of the last trade of the day (when the market closes).

3.Is the American option path dependent?

Only if exercising early would be the appropriate path for you.

4.Why is the American option exercised frequently?

Traders may exercise an American option when the price of the stock fluctuates and trading at the new price would be more profitable for them than waiting out the duration of the contract

DailyForex.com Team
The DailyForex.com team is comprised of analysts and researchers from around the world who watch the market throughout the day to provide you with unique perspectives and helpful analysis that can help improve your Forex trading.

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