Definition
An American Option is a financial derivative contract that gives the holder the right, but not the obligation, to buy or sell an asset at a specified price anytime before a predetermined expiration date. It’s called ‘American’ because it can be exercised anytime unlike ‘European Options’ that can only be exercised at expiration. These options can be applied to a wide variety of assets including stocks, bonds, commodities, or other financial instruments.
Phonetic
The phonetics of the keyword “American Option” is: əˈmɛɹɪkən ˈɑpʃən
Key Takeaways
<ol> <li><strong>American Option provides more flexibility:</strong> One of the major advantages of an American Option is that it can be exercised any time up to its expiration date. This allows the holder to capitalize on any favorable price movements during the option’s life.</li> <li><strong>They are typically priced higher than European options:</strong> Since American options offer more flexibility to the holder, they tend to be priced higher than European options, which can only be exercised at expiration.</li> <li><strong>Risk and Return Calculation:</strong> The calculation for risk and possible returns are more complex for American options given that they can be exercised at any time prior to expiry. Due to this nature, they often require a more sophisticated pricing model.</li></ol>
Importance
The business/finance term “American Option” is important because it offers a unique level of flexibility for investors. An American Option is a type of options contract that allows the holder to exercise the option at any point before and up to its expiration date. This means investors can choose to buy or sell a security at a specified price whenever it is most advantageous for them during the contract’s lifespan. This could be especially beneficial if market conditions change suddenly or unpredictably. It contrasts with a European Option, which can only be exercised on its expiration date, and thus adds an extra layer of possibility for strategic decision-making in the financial markets.
Explanation
An American Option serves a specific purpose in the world of finance, particularly in trading and hedging risk. It provides its holder maximum flexibility as it can be exercised at any time up to its expiration date. This feature allows the holder to take advantage of favorable price movements and potentially maximize their financial gain. Whether it’s to secure a profit or to prevent a loss, the decision to exercise the American Option can be made whenever it’s most advantageous to the holder.The utilization of American Options extends to various sectors, all well-engaged in financial risk management, including individual investors, portfolio managers, and corporations. For individual investors, this type of option provides an avenue for them to speculate on the prices of underlying assets such as stock, hoping the market will swing their way. Portfolio managers often use American Options as insurance against substantial downward movements in the market. Meanwhile, corporations leverage these options as part of their risk management strategies to hedge against significant fluctuations in costs or revenues due to changes in market prices.
Examples
1. Stock Options: A simplistic example of an American option in the real world is a stock option. Suppose you purchase an American option for shares of Apple Inc, which gives you the right to buy the shares at a strike price of $120 anytime within the next three months. If the stock price is currently trading at $110 but rises to $130 in two months, you have the opportunity to exercise the option immediately to save money, buying shares for $120 when they actually cost $130. This distinguishes it from a European option, where you’d have to wait until the option’s expiry date to exercise it.2. Real Estate Options: In real estate, American options could be equated to a flexible lease or buying agreement. For example, someone may secure an agreement to purchase a specific property at a set price within the next year. Should the market cause the property value to increase significantly six months in, the person can exercise their option to buy at the previously agreed upon price and potentially sell it at a higher market price.3. Commodity Options: In commodity markets, an American option might permit a farmer to sell a certain quantity of a commodity, like wheat, for a certain price at any point before the option’s expiration date. If the market price drops dramatically midway before the expiration date, the farmer could exercise their option earlier and sell the wheat at the previously agreed upon higher price, minimizing their losses. In contrast, under a European option, the farmer would have to wait for the expiration date to exercise the option.
Frequently Asked Questions(FAQ)
What is an American Option?
An American Option is a type of financial option contract that can be exercised at any time up to its expiration date. It gives the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price.
How is an American Option different from a European Option?
The main difference is about when the options can be exercised. American options can be exercised any time before the expiry date while European options can only be exercised at expiration.
What are the types of American Option?
There are two types of American Options, namely the American call option and the American put option. The former gives the holder the right to buy an asset while the latter gives the right to sell an asset.
Where are American Options commonly traded?
American Options are most commonly traded on all major exchanges and are the most commonly used form of an option contract in the United States.
How can I exercise an American Option?
An American option can be exercised by instructing your broker to do so. The broker will then let the exchange know, and the exchange will ensure the option is exercised and that the transaction is appropriately settled.
What happens when an American option is exercised?
When an American option is exercised, the holder buys or sells the underlying asset at the agreed strike price. Once exercised, the option contract ceases to exist.
What factors influence the price of an American Option?
Several factors influence the price including the price of the underlying asset, the strike price, the length of time to expiry, volatility, risk-free interest rates, and dividends.
What does ‘in the money’ , ‘at the money’ , and ‘out of the money’ mean in terms of American Options?
An option is ‘in the money’ if exercising it results in a profit, ‘at the money’ if the price of the underlying asset is identical to the strike price of the option, and ‘out of the money’ if exercising the option would not be profitable.
Can I sell the American Option before expiration?
Yes, an American option can be sold at any time before the expiration date, assuming there’s a market for it.
Related Finance Terms
- Exercising Rights: This term refers to the privilege of the holder of an American option. They have the right to exercise or purchase the underlying asset at any time before the expiration date.
- Expiration Date: This is the specific date until when the holder can exercise the American option.
- Strike Price: This is the price at which the holder of the American option can buy or sell the underlying asset.
- Underlying Asset: This is the specific asset for which the American option is written. It can be stocks, bonds, commodities etc.
- Premium: This is the upfront cost that the buyer pays to the seller to obtain the American option. It is the price of the option contract itself.
