What is American Option?

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An American option, aka an American-style option, is a version of an options contract that allows holders to exercise the option rights at any time before and including the day of expiration. It contrasts with another type of option, called the European option, that only allows execution on the day of expiration.An American-style option allows investors to capture profit as soon as the stock price moves favorably, and to take advantage of dividend announcements as well.

Definition

An American option is a type of options contract that allows the holder to exercise the option rights at any time before and including the expiration date. Unlike European options, which can only be exercised on the expiration date, American options provide flexibility for investors to profit from favorable stock price movements and benefit from dividend announcements.

Origin

The concept of American options originated in the early 20th century in the U.S. financial markets and matured with the development of the options market. The establishment of the Chicago Board Options Exchange (CBOE) in 1973 marked the beginning of standardized options trading, with American options being a significant component.

Categories and Features

American options are primarily divided into call options and put options. A call option gives the holder the right to purchase the underlying asset at a fixed price before the expiration date, while a put option gives the holder the right to sell the underlying asset at a fixed price before the expiration date. The main feature of American options is their flexibility, allowing the holder to exercise rights at any time, which is particularly advantageous during high market volatility. However, this flexibility also makes American options more complex to price and typically more expensive than European options.

Case Studies

A typical case involves Apple Inc.'s stock options. Suppose an investor holds an American call option on Apple Inc. When Apple announces a new innovative product leading to a significant stock price increase, the investor can choose to exercise the option immediately, purchasing the stock at a lower strike price and profiting. Another case is Tesla Inc.'s American put option. When Tesla's stock price drops due to market volatility, the holder can exercise the option before expiration to sell the stock at a higher strike price, avoiding greater losses.

Common Issues

Common issues investors face with American options include determining the optimal exercise timing and evaluating the true value of the option. A common misconception is that American options are always superior to European options; in reality, the choice between option types should be based on the investor's strategy and market conditions.

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