An American option is a version of an options contract that allows option holders to exercise option rights at any time up until the day the contract expires. It differs from the European option contract, which allows contract execution only on the day of expiry. Note that the term American and European has nothing to do with the geographical location of the option contract, but only refers to the method of executing the rights of the contract.
How does the American option trade?
American options define the time frame in which the option holder can exercise the rights of the option contract “expiration date”. These rights allow the holder of the option to buy or sell the underlying asset, depending on whether the option is a call option or a put option. The sale or purchase must take place at the execution price specified in the contract on or before the predetermined expiration date. Because investors are free to exercise their options contracts at any time during the life of the contract, the price of an American option contract is higher than that of European limited options.
Finally, the last day to exercise a weekly American option is usually the Friday of the week in which the option contract expires. While the last day to exercise the monthly American option is usually the third Friday of the month.
An example of trading an American option
Supposing an investor buys an American call option of Apple in March with an expiration date at the end of December of the same year. The contract premium “contract price” is $5 per share. Note that one contract includes 100 shares ($5 x 100 = $500). Also, the strike price on the option is $100.
Supposing that after the purchase, the share price rises to $150 per share. Here the investor exercises the call option on Apple shares before expiration by purchasing 100 shares for $100 each. In other words, the investor would acquire 100 Apple shares at the strike price of $100, and immediately sell them at the current market price of $150 to make a profit of $50 per share. So, the investor’s net profit = (50 * 100) minus the premium ($500 for buying the option and any broker’s commission, let’s say $100) = 5000 – 600 = 4400 USD.
What are the advantages of trading an American option?
American options are beneficial because the investor can execute the contract at the time of the price difference, without having to wait to exercise the option at the time of expiration.
What are the downsides of trading an American option?
It charges a higher price and is not available for index options.
What is the difference between an American option and a European option?
An American option can be exercised at any time prior to expiration which gives flexibility and control. While European options can only be exercised at the time of expiry, not at any earlier time. Also, American options are usually more expensive than European options.
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