Title: What an American Option Is — a concise explainer
Definition
– An American option is an options contract that gives its buyer the right to exercise — that is, to buy (call) or sell (put) the underlying asset at the stated strike price — at any time up to and including the option’s expiration date. This contrasts with a European-style option, which can only be exercised on the expiration date itself.
How it works (key points)
– Holder rights: If you own an American call, you may demand delivery of the underlying shares at the strike price any day during the option’s life. If you own an American put, you may require the seller to buy the shares at the strike price at any time up to expiration.
– Exercise window: The exercise window includes the expiration day. For many exchange-traded weekly options the last exercise day is the Friday of that week; for many monthly options the last exercise day is the third Friday of the month.
– Value: Because of the flexibility to exercise early, American-style contracts generally command a higher market value (premium) than otherwise-identical European contracts. That extra value reflects the option buyer’s expanded choice.
– Geography note: The labels “American” and “European” describe exercise rules only — they do not indicate where the option trades.
When investors consider early exercise
Reasons that may justify exercising before expiration:
– Dividends: If a stock will go ex-dividend (the date by which you must own shares to receive the next payment), a holder of a profitable call may exercise before the ex-dividend date to capture the dividend. Option holders do not receive dividends.
– Deep in-the-money (ITM) positions: Calls or puts that are far ITM are sometimes exercised early. As a rough guide from market practice: “deep” often means more than a $10 gap for higher-priced stocks or around $5 for low-priced names. (Rules vary by market and broker.)
– Cash needs or redeployment: Exercising a put delivers cash proceeds immediately (you sell the shares at the strike price), which can be reinvested; this is sometimes described as addressing the cost of carry or an opportunity cost.
Counterpoint: Often traders find it cheaper to sell the option in the market (i.e., close the position) rather than exercising, because the option price already reflects intrinsic value plus any remaining time value.
Pros and cons (quick list)
– Advantages
– Flexibility to exercise at any time.
– Ability to capture dividends by converting to shares before the ex-dividend date.
– Ability to realize gains immediately and redeploy proceeds.
– Disadvantages
– Typically higher premium than otherwise similar European options.
– Exercising early may forfeit remaining time value — the option could gain additional value if held.
– Not all index options are American-style; many index options are European-style.
Checklist before you exercise an American option
1. Confirm intrinsic value: Is the option in-the-money (ITM)? (Intrinsic value for calls = stock price − strike; for puts = strike − stock price.)
2. Check time value: Would exercising eliminate remaining time value? Compare option market premium vs. intrinsic value.
3. Look up ex-dividend date: Is a dividend imminent that makes exercise favorable?
4. Estimate costs: Consider commissions, fees, assignment costs and tax consequences.
5. Consider alternatives: Could you sell the option for a better net outcome than exercising?
6. Verify broker rules: Know your broker’s cut-off times and automatic exercise policies.
7. Confirm liquidity: Ensure the option or underlying stock is liquid enough to transact at fair prices.
Worked numeric example (step-by-step)
Scenario: You bought one American-style call on Company X.
– Contract details:
– Strike price = $100
– Premium paid = $5 per share
– Each contract = 100 shares → premium paid = $5 × 100 = $500
– Later, stock price = $150 per share.
Option exercise calculation:
1. Intrinsic gain from exercising = (market price − strike) × 100 = ($150 − $100) × 100 = $5,000.
2. Net profit after subtracting premium = $5,000 − $500 = $4,500.
Notes/assumptions:
– This example ignores transaction costs (broker commissions), bid-ask slippage, and taxes, all of which reduce net proceeds.
– Alternative action: Instead of exercising, you could sell the call in the market. The sale price would usually reflect the same intrinsic value plus any remaining time value — sometimes selling is more efficient than exercising.
Practical tip
Before exercising, calculate the option’s intrinsic value, estimate remaining time value, check for any upcoming dividend dates, and compare the net proceeds of exercising versus selling the option.
Reputable sources for further reading
– Investopedia — “American Option” — https://www.investopedia.com/terms/a/americanoption.asp
– Chicago Board Options Exchange (CBOE) — Education center — https
://www.cboe.com/education/
– Options Industry Council (OIC) — Options education and calculators — https://www.optionseducation.org/
– U.S. Securities and Exchange Commission (Investor.gov) — Options: basics and risks — https://www.investor.gov/introduction-investing/investing-basics/investment-products/options
– Khan Academy — Derivative securities (introductory lessons on options) — https://www.khanacademy.org/economics-finance-domain/core-finance/derivative-securities
Educational disclaimer: This information is for educational purposes only and does not constitute personalized investment advice. Options involve risk and are not suitable for all investors; consult a qualified financial professional for guidance specific to your situation.