Finance

American Option

American Option

Options can be called a versatile financial product. Options are a type of derivative that depends on the value of the underlying asset. The underlying asset can be a commodity, currency, stock, index, or any other security. Now, the option contract is a financial contract that gives the investor an opportunity to buy or sell an asset at a pre-determined price at a specific date.

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There are two types of options which are the call option and put option. The call option allows the investor to buy the asset at a specific price on a specific date. A put option allows the investor to sell the asset at a specific price on a specific date. The strike price is the stated price on an option. Every option contract has an expiration date by which the holder must exercise the option. Online or retail brokers are the ones who usually buy and sell the options. Put option and call option form a basis for a wide range of option strategies which are designed for hedging, speculating, and income.

A version of an option is the American option. It allows the holders to exercise the options any time before or even on the day of maturity is possible. This gives an additional advantage of tradability which makes it the highly traded option in the market. It also allows the investors to earn profit as soon as there is some movement in the prices of the stocks. American options are also highly liquid in nature. Although they can be exercised early an added premium or cost is charged. The name American option has nothing to do with the geographical location but only applies to the style of execution. The last day to exercise a weekly option is usually on the Friday of the week the contract expires and in the case of a monthly option, it’s normally the third Friday of the month.

How Does It Work?

The working of an American option can better be understood with the help of an example. Mr. A purchased an American call options contract from Apple Inc in February and the expiration was in September of the same year. He bought one contract which consisted of 100 shares and the strike price was $150. The investor is in the long position of 100 shares of Apple Inc at the $150 strike price. After the purchase of the contract, the price rose to $175. He looks at this as an opportunity to make a profit by selling each at $175 and making a profit of $25 per share. This example shows us that Mr. A purchased an American option as he was able to call the option before the expiration date.

An investor thinks that the prices will decline in the coming days so he purchases an American put option from company S in march which expires in July of the same year. He buys one contract of 100 shares at a strike price of $120. The prices of the company’s shares fall to $80 so the investor uses the put option and sells the currently owned shares for $120 per share and buys at $80. After a few days sell them at $120 thereby earning a profit of $40(the net difference is settled in practice).

Buying and selling of American option:

Most of the American options are bought and sold on the exchange. One of the easier way ways is to appoint a broker who will do the transactions on behalf of the investor. The most preferred way to sign up with an online broker.

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Advantages

  • The biggest and most important advantage is to exercise the option contract any time before the expiration date.
  • It allows facilitating the profits to be optimally utilized and also promotes an increase in market activity.
  • The investor has the ability to exercise the contract before the ex-dividend date which allows the option holder to own the stocks and also be eligible for the next dividend payment period.

Disadvantages

  • An American option is expensive since the premium charged is higher compared to a European option when the option is exercised before the maturity.
  • The option holder potentially loses out on the appreciation opportunity when the option is called off earlier.

An American option gives the option holder the flexibility to reap maximum benefits as it allows to exercise the contract when the security or stock is favorable to the option holder.

Author -Sanjana Rau

About the author- Started my journey of self even when the odds were against me, keen observation, a cool temper, and sports worked the best for me.

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