American OptionsAugust 4, 2021 2021-08-04 6:18
Definition of American Option
An American option is a kind of derivative contract that can be exercised by the option holder at any given time before or at the date of expiration which gives the benefit to the holder of the option to make profits as and when the price of the stock moves favorably.
What is American Option?
American options give an option holder right, not an obligation, to buy or sell the security on any given date before the date of expiration. The American option allows the holder to book gains as soon as the price of the security moves in a direction which is favorable for the investor. There is another version of the option known as the European option that can be executed only at the date of expiration.
Example of American Options
Let’s take the example of an investor Mr. X who expects that the share price of XYZ Ltd. will increase in near future and the current market price is $ 50 per share. So Mr. X purchased an American call option on 1st March 2020 that consists of 500 shares whose strike price is $60 and premium are $10 per share and the date of expiration is 28th December 2020. Now on 15th November 2020, the price of the share goes to $90. Now calculate the profit if the option is exercised by Mr. X on 15th November 2020.
|Number of Shares||A||500|
|Premium per share||C||$10|
|Total premium paid [A*C]||D||$5,000|
|Option Exercise Price [A*B]||E||$30,000|
|Selling Price of the stock||F||$90|
|Total selling price||G||$45,000|
Therefore profit as of 15th November 2020 is $10,000 and choosing the option proved beneficial to the investor.
Types of American Options
There are two types of American options and they are as under:
1. American Call Option:
American call option allows the option holder to exercise their right on any day within the period of contract i.e. on any day before the expiration period or on expiration day when the stock price increases above the contract strike price. It is a right to the investor to exercise the option and not an obligation and the strike price remains the same over the period of contract. If the investor buys the American call option for the given company in April having the expiration date at the end of June of the same year then the investor can exercise the call option until June.
2. American Put Option:
American put option allows the option holder to exercise their right on any day within the period of contract i.e. on any day before the expiration period or on expiration day when the stock price decreases below the contract strike price. It is a right to the investor to exercise the option and not an obligation and the strike price remains the same over the period of contract.
Where is American Options Traded?
American options are traded mainly over an exchange.
When to buy American Options?
American options should be purchased when the value of the option is at a low level. It gives the opportunity to the option holder to exercise the option when the price of the option rises further. As the American option gives the option holder the right to exercise the option before the maturity date and there is flexibility for the option exercised, the option holder can earn the maximum profit according to the rise in the market value of the option. Hence, it is advisable to buy the American option when the value of the option is low as per the market.
American Option Pricing
To buy the American option, the price is required to be paid to get the privilege that is given by an American call option which is known as the premium. The premium is to be paid while entering into an option to the broker which is then passed on to the seller of the option also known as the writer. The premium is dependent upon various factors and varies from asset to asset. Generally, the premium is some small percentage of the underlying security.
Also in the case of the American option, the amount of premium is large. Therefore, American option pricing always affects how much the investor can leverage. The higher premium indicates lower leverage and the situation of generating higher profits will therefore be more moderate.
Advantages of American Options
The advantages of American options are as under:
- The main advantage of American option is that the option can be exercised at any time during the period of contract.
- The ability of the investor to exercise the right before the ex-dividend date enables the investor to own the asset and receive the next payment of dividend.
- American option also facilitates the optimal utilization of profits and promotes the increase in market activity.
Disadvantages of American Options
The disadvantages of American options are as under:
- As compared to the European option, the American options are expensive as the amount of premium is higher due to the benefit is given in the American option to exercise the option any time before the expiration date.
- There is a possibility that the option holder may lose the profits if the option is exercised before the expiration date and the price increase/decreases after the exercise date as per the case may be.
Thus, American call options are the contract that gives the right to the buyer to exercise the option during the time of contract period and book the profits at any time before the expiration of the contract period. It also facilitates the optimal utilization of profits and promotes an increase in market activity.