An American option is that financial option that can be exercised by the buyer at any time, before and on expiration.
Remember that a financial option gives the right to the buyer (in exchange for the payment of a premium) and the obligation to the seller to buy or sell a certain underlying asset . And this from a pre-established price and expiration date. Therefore, the advantage of an American option is that the buyer can exercise the option to buy or sell at any time. And therefore, not having to wait for the expiration of the same, as if it happens with the European options.
Advantages of an American option
The American options have a series of advantages that differentiate them from other types of options that if they are required to remain due. Let’s discuss some below:
- Freedom of exercise. The buyer’s ability to exercise the option at any time until expiration is an important factor. In fact, it is a very valuable factor for investors.
- Collection of benefits. An American option allows investors to reap benefits as soon as the price of the underlying asset moves in their favor. Since, it can be exercised at any time.
- Exercise before the day by dividing. In the case of American stock options, it allows the buyer of a stock option to exercise the option and obtain the dividendson that stock. Let’s explain this part a little more:
The buyer of a stock option receives no dividend payment for the stock option. Therefore, the investor can exercise the option before the ex-dividend day of the share (cut-off day to see who the shareholders are and collect the next dividend), obtain the shares and thus be able to collect the dividend.
Disadvantages of an American option
Let’s see some of the cons that these types of options have for investors in practice:
- Higher cost in the premium. Due to the advantage of freedom of exercise at any time during the life of the option, the premium of these options is usually higher than the European options.
- Investment in indexes limitation. Despite the wide range of underlying assets for the American options, there is some limitation. The limitation we are talking about is that of stock indices. In other words, the options on indices are usually European and not American. Therefore, if we want to invest in index options, we will not have the advantage, for example, of freedom of exercise.
American Options Example
Let’s imagine for this example that we bought an American call option on Twitter, Inc. shares today with expiration in 6 months. That is, the right to buy those shares with the following conditions:
- A call option on Twitter shares (100 shares per contract)
- Option premium price $ 2. 2 x 100 shares: $ 200 premium
- Exercise price: $ 30 per share.
- Today’s market price: $ 29 per share.
After 3 months from purchase, Twitter’s share rises to $ 35. In this case we decide to exercise the purchase option at the stipulated exercise price and instantly sell them on the market. How would the operation look like?
We would have a total cost of $ 3,200, $ 200 premium plus the purchase of the 100 shares at a price of $ 30.
In the case of income, it would be a total income of $ 3,500 for the market sale of the 100 shares at a price of $ 35. Therefore, the operation would be closed with a profit of $ 300.