American options

What Are American Options?

American options are a type of option contract that grants the holder the right, but not the obligation, to buy or sell an underlying asset at a specified strike price at any time before or on the expiration date. This flexibility to exercise at any point distinguishes American options within the broader category of derivatives. Unlike other option types, the defining characteristic of an American option lies in its early exercise feature, which can impact its option premium and overall value.

History and Origin

The concept of options trading has roots stretching back centuries, with informal agreements to buy or sell assets at a future date existing long before formalized exchanges. However, the modern era of standardized options, including American options, began with the establishment of the Chicago Board Options Exchange (CBOE). The CBOE launched on April 26, 1973, revolutionizing the market by offering standardized contracts with set terms, centralized clearing, and transparent pricing¹⁰, ¹¹, ¹². Before this, options were traded over-the-counter (OTC) with no standardized terms, often requiring direct links between buyers and sellers⁹. The CBOE's innovation provided a more efficient and accessible marketplace for various option contract types, including those with American-style exercise. The Securities and Exchange Commission (SEC) also plays a role in regulating options trading in the U.S. markets⁶, ⁷, ⁸.

Key Takeaways

• American options offer the holder the flexibility to exercise the option at any point between the purchase date and the expiration date.
• This early exercise feature differentiates American options from other types, which typically only allow exercise at expiration.
• The ability to exercise early can be valuable, particularly for put option holders when the underlying asset pays dividends or for deep in-the-money options.
• American options are commonly traded on organized exchanges in the United States and are regulated by bodies like the SEC.
• Their valuation is more complex than European options due to the added flexibility of early exercise.

Interpreting the American Options

The primary interpretation of American options revolves around their exercise flexibility. For a call option, the holder can buy the underlying asset at the strike price anytime up to and including the expiration date. For a put option, the holder can sell the underlying asset at the strike price anytime up to and including the expiration date. This right to early exercise means that the American option's value will generally be equal to or greater than its corresponding intrinsic value and can command a higher option premium compared to a European option, all else being equal. The decision to exercise an American option early depends on various factors, including dividend payments, interest rates, and the volatility of the underlying asset.

Hypothetical Example

Consider an investor, Sarah, who buys an American call option on Company XYZ stock.

• Underlying Asset: XYZ stock, currently trading at $50 per share.
• Strike Price: $55
• Expiration Date: Three months from now
• Option Premium: $2.00 per share (or $200 per contract, as each contract typically represents 100 shares).

If XYZ stock unexpectedly announces a large dividend payment in one month, and its price jumps to $60, Sarah might consider exercising her American option early. By exercising, she buys 100 shares of XYZ at the exercise price of $55 per share, immediately captures the $5 per share intrinsic value ($60 market price - $55 strike price), and becomes eligible for the dividend. If she waited, the dividend payment would likely reduce the stock price after the ex-dividend date, diminishing the option's value. This early exercise is a key advantage of American options.

Practical Applications

American options are widely used by investors for both speculation and hedging purposes. Their ability to be exercised at any time provides greater tactical flexibility compared to European options.

• Speculation: Traders might buy American call options if they anticipate a significant upward movement in an underlying asset's price and wish to profit from it with leveraged exposure. Conversely, buying American put options allows investors to profit from expected price declines. The flexibility to exit the position by exercising early can be beneficial if the anticipated move happens sooner than expected.
• Hedging: Portfolio managers often use American put options to protect existing stock holdings from potential downturns. By holding a put option on a stock they own, they can lock in a minimum selling price. If the market experiences sudden volatility, as noted in recent market activity that has boosted options trading volumes, the ability to exercise the put immediately provides an effective risk management tool⁴, ⁵. The Federal Reserve Bank of San Francisco has also published economic letters discussing how options reflect market uncertainty and contribute to the functioning of financial markets¹, ², ³.
• Income Generation: Selling covered American call options against existing stock holdings can generate income (the premium) for investors, although it caps their upside potential.

Limitations and Criticisms

While American options offer flexibility, they also come with certain complexities and considerations:

• Valuation Complexity: The ability to exercise an American option at any time makes its theoretical valuation more intricate than that of European options. There is no simple closed-form solution like the Black-Scholes model for European options; instead, numerical methods such as binomial tree models or finite difference methods are typically used. This complexity can make it harder for individual investors to fully grasp the nuances of their time value and optimal exercise strategies.
• Early Exercise Suboptimality (for Calls): For American call option on non-dividend-paying stocks, it is generally considered suboptimal to exercise early. This is because the option holder benefits from the remaining time value and the interest that could be earned on the strike price funds if exercise is deferred. Exercising early means forfeiting this time value.
• Transaction Costs: Frequent trading or early exercise of American options can incur more transaction costs (commissions, bid-ask spread) compared to holding an option until expiration.
• Risk of Misjudgment: The discretion to exercise early introduces a decision point that, if poorly timed, can lead to suboptimal returns or even losses. Understanding the factors influencing optimal early exercise, such as significant dividend payouts or deep in-the-money puts, is crucial.

American Options vs. European Options

The fundamental distinction between American options and European options lies in their exercise rights.

The confusion often arises because the names "American" and "European" refer to the exercise style, not the geographic location where they are traded. An American option can be traded globally, just as a European option can.

FAQs

Q: Why would someone choose an American option over a European option?

A: Investors might choose American options for the added flexibility of exercising the option contract at any time before or on the expiration date. This can be advantageous in scenarios like capturing a large dividend payout from the underlying asset or hedging against sudden market movements, allowing for immediate profit taking or loss mitigation.

Q: Do American options always have a higher premium than European options?

A: Generally, yes. Because American options offer more flexibility (the right to exercise early, in addition to exercising at expiration), they are at least as valuable as, and typically more valuable than, a comparable European option with the same strike price and expiration date. The extra value comes from this additional right.

Q: What factors influence the decision to exercise an American option early?

A: The decision to exercise an American option early is complex and depends on factors such as dividend payments (for calls), interest rates, the amount the option is in-the-money, and potential changes in volatility. For instance, it can be optimal to exercise an American put option early if the underlying asset's price drops significantly, allowing the holder to lock in profits or avoid further losses.