What Are American Style Options?
American style options are a type of option contract that gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specified strike price at any time on or before the expiration date. This flexibility to exercise the option early distinguishes American style options within the broader category of derivatives trading. Whether a call option (right to buy) or a put option (right to sell), the key characteristic of American style options is the ability for the holder to "exercise" the contract before its maturity, unlike their European counterparts. This feature provides greater flexibility, which can be valuable in certain market conditions. American style options are a fundamental instrument in options trading and are widely traded on exchanges.
History and Origin
The concept of options trading, in various forms, dates back centuries, with early examples like the philosopher Thales of Miletus speculating on olive presses in ancient Greece. However, the modern era of standardized options trading, including American style options, truly began in the United States with the establishment of the Chicago Board Options Exchange (CBOE). The CBOE, founded in 1973, became the first marketplace for trading listed options, introducing standardized contracts that brought greater transparency and liquidity to the market.4 Before this, options were primarily traded over-the-counter with less standardized terms. The concurrent development of sophisticated pricing models, such as the Black-Scholes model, which was published in the same year, provided a theoretical framework that further propelled the growth and understanding of these complex financial instruments.3 This standardization and theoretical grounding laid the foundation for the widespread adoption of American style options.
Key Takeaways
- American style options grant the holder the flexibility to exercise the option at any time up to and including the expiration date.
- This early exercise feature contrasts with European style options, which can only be exercised at expiration.
- The value of American style options incorporates this early exercise privilege, which can influence their premium.
- They are commonly used for both speculation and hedging strategies.
- Understanding the factors influencing their value, such as volatility and time value, is crucial for traders.
Formula and Calculation
While there isn't a simple closed-form formula like the Black-Scholes model for European options that precisely prices American style options, their value can be determined using more complex numerical methods. This complexity arises due to the early exercise feature. The Black-Scholes model assumes that the option can only be exercised at maturity, making it directly applicable only to European style options.
For American style options, pricing typically involves numerical methods such as:
- Binomial Option Pricing Model: This model discretizes time into a series of periods, allowing for the evaluation of the option at each potential exercise point. It builds a tree of possible underlying asset prices, moving backward from expiration to the present. At each node, the model compares the value of exercising the option immediately with the value of holding it.
- Finite Difference Methods: These methods solve the partial differential equations (PDEs) that govern American option prices numerically.
- Monte Carlo Simulation: While more common for path-dependent options, Monte Carlo methods can be adapted for American options by incorporating techniques for approximating optimal early exercise boundaries.
The core idea behind these methods is to account for the optimal decision-making process of the option holder at every possible moment prior to expiration. This means considering both the option's intrinsic value if exercised immediately and its potential future value if held.
Interpreting American Style Options
The primary interpretation of American style options revolves around their embedded early exercise right. For a call option, this means that if the underlying asset's price rises significantly above the strike price before expiration, the holder can choose to exercise immediately to capture profits, especially if dividends are expected or if the cost of carrying the option (e.g., interest on borrowed funds) outweighs its remaining time value. Similarly, for a put option, if the underlying asset's price falls well below the strike price, immediate exercise allows the holder to sell at the higher strike price, locking in gains or mitigating losses.
This early exercise feature makes American style options more valuable than comparable European style options, as they offer greater optionality. Investors interpret a higher premium for an American option (compared to its European counterpart) as the market's pricing of this added flexibility. The decision to exercise early is often complex, influenced by factors such as dividends, interest rates, and the volatility of the underlying asset.
Hypothetical Example
Consider an investor, Alice, who believes that Company XYZ's stock, currently trading at $50 per share, will rise significantly in the next three months. She decides to buy an American style call option on XYZ with a strike price of $55 and an expiration date three months from now. The premium she pays is $2.00 per share, or $200 for one contract (representing 100 shares).
One month later, Company XYZ announces unexpectedly strong earnings, and its stock price jumps to $65 per share.
- Scenario 1: Alice holds the American style option. She could choose to hold the option, hoping the price will go even higher. However, she could also consider exercising it immediately to lock in her profit.
- Scenario 2: Alice exercises the American style option early. Because it's an American style option, she can exercise her right to buy 100 shares of XYZ at $55 each, even though the market price is $65.
- Her cost to buy the shares: $55 (strike price) * 100 shares = $5,500
- She then sells these 100 shares in the open market at the current price: $65 * 100 shares = $6,500
- Gross profit from the stock transaction: $6,500 - $5,500 = $1,000
- Net profit after accounting for the initial premium paid: $1,000 - $200 = $800
If this were a European style option, Alice would not have the ability to exercise early and would have to wait until the expiration date, exposing her to potential price fluctuations over the remaining two months. The American style option gives her the power to act on favorable price movements immediately.
Practical Applications
American style options are versatile tools with various practical applications in financial markets:
- Speculation: Traders use American style options to speculate on the price movements of underlying assets. For example, purchasing an American style call option allows a bullish investor to profit from upward price movements with a limited initial capital outlay.
- Hedging: Investors employ American style options to hedge against adverse price movements in their existing portfolios. A portfolio holder concerned about a potential short-term decline in a stock they own might buy American style put options to protect against losses. If the stock falls, the put option gains value, offsetting some of the stock's decline. This use is a common risk management strategy.
- Income Generation: Selling covered call options (where the seller owns the underlying stock) is a strategy used to generate income from the premium received. While typically not exercised early by the buyer in a profitable scenario for the seller, the American style feature gives the buyer that flexibility.
- Arbitrage: The early exercise feature can create opportunities for arbitrage under specific conditions, although these are typically fleeting and exploited by sophisticated algorithms.
- Corporate Finance: Companies may issue American style employee stock options to incentivize employees, allowing them to purchase company stock at a predetermined price, often providing flexibility in when they can exercise their options.
Regulatory bodies like the U.S. Securities and Exchange Commission (SEC) provide educational resources to help investors understand the basics and risks of options trading, highlighting the importance of informed decision-making given the complexity of these instruments.2
Limitations and Criticisms
Despite their flexibility, American style options have several limitations and criticisms:
- Complexity: American style options are more complex to value and understand than European style options due to the early exercise privilege. This complexity can make them challenging for novice investors.
- Increased Premium: Because they offer the added flexibility of early exercise, American style options typically command a higher premium than comparable European style options, reducing potential profit margins for buyers.
- Optimal Exercise Dilemma: Deciding when to exercise an American style option early can be difficult. While the right exists, early exercise is often not optimal for call options unless significant dividends are pending. For put options, early exercise can be optimal more frequently. Misjudging the optimal exercise point can lead to sub-optimal returns.
- Risks for Sellers (Writers): For those who write (sell) American style options, the risk profile can be substantial, especially for uncovered (naked) options. An unexpected early exercise by the buyer can force the seller to take an action (buy or sell the underlying) that results in a significant loss, particularly if the market moves sharply against their position.
- Time Decay (Theta): Like all options, American style options are subject to time decay. As the expiration date approaches, the extrinsic value of the option erodes, accelerating rapidly in the final days or weeks. This decay means that even if the underlying asset moves in the desired direction, if it doesn't move enough or quickly enough, the option can still expire worthless.
These factors underscore the need for a thorough understanding of options mechanics, including volatility, before engaging in American style options trading.
American Style Options vs. European Style Options
The fundamental difference between American style options and European style options lies in their exercise restrictions.
| Feature | American Style Options | European Style Options |
|---|---|---|
| Exercise Right | Can be exercised at any time up to and including expiration date. | Can only be exercised on the expiration date itself. |
| Flexibility | Higher flexibility, allowing for early profit taking or risk mitigation. | Lower flexibility, fixed exercise point. |
| Premium | Generally command a higher premium due to greater flexibility. | Generally have a lower premium. |
| Underlying Assets | Common for individual stocks and ETFs. | More common for index options and certain currencies. |
| Pricing Models | Require complex numerical models (e.g., binomial trees, finite difference). | Often priced using closed-form analytical formulas (e.g., Black-Scholes). |
Confusion often arises because the names "American" and "European" refer to the exercise style, not the geographic location where the options are traded. Both types of options are traded globally. The ability to exercise early is the distinguishing characteristic of American style options, offering a strategic advantage that must be weighed against their higher cost and valuation complexity.
FAQs
Can an American style option be exercised after its expiration date?
No, an American style option cannot be exercised after its expiration date. Once the expiration date passes, the contract becomes worthless if it has not been exercised.
Why would someone choose American style options over European style options?
Investors might choose American style options for the added flexibility of early exercise. This can be advantageous in situations where dividends are expected, or if a significant price movement allows the holder to lock in profits or reduce losses before the expiration date. This flexibility allows for more dynamic options trading strategies.
Are American style options riskier than European style options?
The risk profile for buyers of American style options is similar to European style options, limited to the premium paid. However, for sellers (writers) of American style options, the risk can be higher due to the potential for unexpected early exercise, which can force an undesirable transaction. Understanding the nuances of both types of options is important for managing risk.
Is the Black-Scholes model used to price American style options?
The original Black-Scholes model is designed to price European style options because it assumes exercise only at maturity. For American style options, variations or numerical methods like the binomial option pricing model are typically used to account for the possibility of early exercise.1
What happens if I don't exercise my American style option before expiration?
If you do not exercise your American style option before its expiration date, and it is "in-the-money" (meaning it has intrinsic value), it will typically be automatically exercised by your brokerage firm. If it is "out-of-the-money" or "at-the-money," it will expire worthless, and you will lose the entire premium paid for the option.