American option

derivatives

An American option is a financial option that can be exercised by the buyer at any time, before and at maturity.

Remember that a financial option gives the right to the buyer (in exchange for the payment of a premium) and the obligation to the seller to buy or sell a certain underlying asset. And this from a pre-established price and expiration period. Therefore, the advantage of an American option is that the buyer can exercise the purchase or sale option at any time. And therefore, not having to wait for the expiration of it, as if it happens with the European options.

Advantages of an American option

American options have a series of advantages that differentiate them from other types of options that are forced to hold to maturity. Let's comment on a few below:

  • Freedom of exercise. The ability of the option buyer to exercise it at any time until expiration is an important factor. In fact, it is a very valuable factor for investors.
  • Collection of benefits. An American option allows investors to take profits as soon as the price of the underlying asset moves in their favor. Since, it can be exercised at any time.
  • Exercise before the day ex-dividend. In the case of American stock options, it allows the buyer of a call option on shares to exercise the option and obtain the dividends of that share. Let's explain this part a bit more:

The buyer of a share option does not receive a dividend payment for it. Therefore, the investor can exercise the option before the ex-dividend day of the share (cut-off day to see who the shareholders are and collect the next dividend), obtain the shares and thus be able to collect the dividend.

Disadvantages of an American option

Let's see some of the cons that these types of options have for investors in practice:

  • Higher cost in the premium. Due to the advantage of freedom to exercise at any time during the life of the option, the premium for these options is typically higher than European options.
  • Limitation of investment in indices. Although the range of underlying assets for American options is very wide, there are some limitations. The limitation we are talking about is that of stock indices. That is, the options on indices are usually European and not American. Therefore, if we want to invest in options on indices, we will not have the advantage, for example, of freedom of exercise.

Example of American options

Let's imagine for this example that we buy an American call option on Twitter, Inc. shares today with expiration in 6 months. That is, the right to buy those shares with the following conditions:

  • A call option on Twitter shares (100 shares per contract)
  • Option premium price $ 2. 2 x 100 shares: $ 200 premium
  • Exercise price: $ 30 per share.
  • Market price today: $ 29 per share.

After 3 months from the purchase, the Twitter share rises to $ 35. In this case, we decide to exercise the purchase option at the stipulated exercise price and instantly sell them on the market. How would the operation be?

We would have a total cost of $ 3,200, a $ 200 premium plus the purchase of 100 shares at a price of $ 30.

In the case of income, it would be a total income of $ 3,500 from the market sale of the 100 shares at a price of $ 35. Therefore, the operation would close with a profit of $ 300.

Financial Options - Types and Examples

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