An American option is a contract that may be exercised at any time on or before the expiration date.
The uniqueness of redeeming the contract before its maturity, or on the date of maturity, gives it an added benefit of tradability. Due to this specific feature, it is the most popular traded option in the world stock exchange.
While there are two types of options, call and put, there also are two main classes of options, American and European, with many similarities and few differences. Entering into American Options with a mindset of European Options, can lead to heavy losses, and can put you off trading all together. I would like to illustrate and give you as much information as possible, to explain to you what the differences are and how you can trade American options.
Why trade with American Options?
American options are more valuable than European-style options, which can only be exercised at the expiration time and date. With an American option, the trader is able to wait for the most expedient price in which to exercise the option. The trader will be able to exercise the option at any of the trading days he chooses leading up to the expiration date. Due to the flexibility of this type of options, the greater the outcome could be, when in-the-money.
Example of Trading an American Option
A trader holding an American option that expires on the third Friday of the month, has the right to exercise that option at any time on or before that date. Since the option price moves in sync with the underlying asset, the value of the option may move upward and downwards many times during the lifetime of that particular contract. American options trade on most major exchanges.
Differences between American and European Options:
|American Options||European Options|
|Owners of American options may exercise at any time before the option expires||Owners of European options may exercise only at expiration|
|American index options stop their trading at the close of business on the third Friday of the expiration month||European index options stop trading one day earlier – at the close of business on the Thursday preceding the third Friday|
|All optionable stocks and traded funds have American style options. Among the broad-based indices, only limited indices have American options AVAILABLE||Major broad-based indices, such as the S&P 500, have very actively traded European options|
Knowing the differences between the above two options allows you to manage your position, time and profits. Knowledge of the settlement amounts of the options you decide to trade will better assist you in avoiding significant losses. Beware if you are a seller of American-style options, you are at risk of being ‘called out’-meaning having your options exercised at anytime, other than that. It is safe to conclude that trading American options, might have a few nasty surprises but it is a more comfortable environment to trade, with regards to settlement prices.
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