What Is an American Option?

What Is an American Option?

Let me explain what an American option is. It's a type of options contract that lets you, as the holder, exercise your rights anytime before or on the expiration date. This differs from a European option, which you can only exercise exactly on the expiration day.

With an American-style option, you can lock in profits the moment the stock price moves in your favor, and you can also benefit from dividend announcements.

Key Takeaways

Here's what you need to know: An American option gives you the ability to exercise at any time up to and including the expiration date. It lets you capture profits as soon as the stock price shifts positively. Plus, these options are often exercised before an ex-dividend date so you can own shares and receive the upcoming dividend payment.

How American Options Work

American options define the period when you can exercise your rights under the contract. Depending on whether it's a call or put, these rights let you buy or sell the underlying asset at the fixed strike price on or before the set expiration date. Because you have the freedom to act anytime during the contract's life, American options are more valuable than European ones, but that flexibility comes with an extra premium cost.

For weekly American options, the last day to exercise is usually the Friday of the expiration week. For monthly ones, it's typically the third Friday of the month.

Most exchange-traded options on individual stocks are American style, while index options are usually European.

Important Note

Just to clarify, the terms 'American' and 'European' refer only to the exercise style, not any geographic location.

American Call and Put Options

A long call option in American style gives you the right to demand delivery of the underlying stock on any day during the contract period, up to and including expiration. You're not obligated to exercise it, and the strike price stays fixed throughout.

For example, if you buy a call option in March expiring in December, you can exercise it anytime until that December date.

American put options work similarly, allowing exercise anytime up to expiration. This means you can force the seller to take delivery if the asset price drops below the strike.

One key reason to exercise a put early is the cost of carry or opportunity cost; exercising pays you the strike price right away, so you can invest those funds elsewhere to earn interest. However, the downside is missing out on dividends, since exercising sells the shares, and you might lose potential further gains if the option value keeps rising toward expiration.

When to Exercise Early

In many cases, you won't exercise American options early because it's often better to hold until expiration or sell the option back to the market. As a stock price rises, a call option's value and premium increase, so you can sell it for a profit equal to the difference in premiums, minus fees.

That said, early exercise happens with deep-in-the-money calls, where the asset price is well above the strike—typically more than $10 in-the-money, or $5 for lower-priced stocks. Puts can be exercised early if deeply in-the-money too.

Early exercise also occurs before a stock's ex-dividend date, so you can capture the dividend as an option holder who doesn't otherwise receive them.

Advantages and Disadvantages of American Options

American options are useful because you don't have to wait for the asset price to exceed the strike before exercising. But they include a premium cost that you must account for in your trade's profitability.

Examples of an American Option

Suppose you buy an American-style call option for Apple Inc. (AAPL) in March, expiring at year's end. The premium is $5 per contract (100 shares, so $500 total), with a $100 strike. If the stock rises to $150, you exercise early, buying 100 shares at $100 and selling at $150 for a $50 per share profit. That's $5,000 total minus the $500 premium and commissions.

Now, imagine you think Meta Inc. (META) shares will drop. You buy a July put option in January, expiring in September, with a $3 premium per contract ($300 total) and $150 strike. If the stock falls to $90, you exercise, effectively selling at $150 after buying at $90, netting $60 per share or $6,000 minus the premium and fees.

Disclaimer

Remember, this information isn't tax, investment, or financial advice. It's general and doesn't consider your specific objectives, risk tolerance, or circumstances. Investing carries risks, including potential loss of principal.