American Style Option

American Style Option

Definition:

Imagine you have the option to buy a house, but you're not obligated to. An American style option is similar. It's a financial contract that gives the holder the right, but not the obligation, to buy (in the case of a call option) or sell (in the case of a put option) an underlying asset at a specific price (strike price) before a specific date (expiration date). This is a type of derivative. This contrasts with European-style options, which can only be exercised on the expiration date.

Key Takeaway: American style options allow holders to exercise their rights at any point before and including the expiration date, offering greater flexibility than European style options.

Mechanics

Let's break down how an American style option works, step-by-step:

1. Contract Purchase: An investor purchases an American style option contract from another party. This contract specifies:

   • Underlying Asset: The asset the option is based on (e.g., a stock like Apple, or a commodity like gold, or even a cryptocurrency like Bitcoin).
   • Option Type: Call (right to buy) or Put (right to sell).
   • Strike Price: The price at which the asset can be bought (call) or sold (put).
   • Expiration Date: The last date the option can be exercised.
   • Contract Size: The number of units covered by one contract (e.g., 100 shares of stock).
   • Premium: The price paid for the option contract.

2. Exercising the Option (Call Option Example): If the investor holds a call option and the market price of the underlying asset rises above the strike price, they can choose to exercise the option before the expiration date. They buy the asset at the strike price, regardless of the current market price. For example, if the strike price is $100 and the market price is $110, the investor buys the asset for $100, and can immediately sell it for $110, profiting. The profit is the difference between the market price and strike price, minus the premium paid for the option.

3. Exercising the Option (Put Option Example): If the investor holds a put option and the market price of the underlying asset falls below the strike price, they can exercise the option. They sell the asset at the strike price, even if the market price is lower. For example, if the strike price is $100 and the market price is $90, the investor sells the asset for $100, profiting. The profit is the difference between the strike price and the market price, minus the premium paid.

4. Holding the Option: The investor can also choose not to exercise the option and simply hold it until expiration. If the option is in the money (profitable to exercise) at expiration, it will be automatically exercised by the brokerage. If it's out of the money (not profitable), it expires worthless, and the investor loses the premium paid.

5. Selling the Option: An investor can choose to sell the option contract to another party at any time before expiration. The value of the option will fluctuate based on the market price of the underlying asset, time to expiration, volatility, and other factors. This allows the investor to potentially profit from the option without ever exercising it.

In the Money (ITM): A call option is ITM when the market price is above the strike price. A put option is ITM when the market price is below the strike price.

Out of the Money (OTM): A call option is OTM when the market price is below the strike price. A put option is OTM when the market price is above the strike price.

At the Money (ATM): An option is ATM when the market price is equal to the strike price.

Trading Relevance

American style options are popular tools for traders due to their flexibility. Here's why and how they are used:

• Hedging: Investors use options to hedge (protect) their existing positions. For example, if an investor owns shares of Apple (AAPL), they could buy a put option to protect against a price decline. If the price falls, the put option gains value, offsetting the losses on the shares. This is like buying insurance.

• Speculation: Traders use options to speculate on the price movements of an asset. They can bet on the price going up (buying a call) or down (buying a put) with a limited risk (the premium paid).

• Leverage: Options provide leverage. A trader can control a large position in an asset with a relatively small investment (the premium). This magnifies both potential profits and losses.

• Early Exercise: The ability to exercise the option at any time is valuable when there are significant events or dividends. For example, if a stock is about to pay a large dividend, a call option holder might exercise the option to receive the stock and the dividend. In cases of a significant market event, the flexibility to exercise early provides a significant advantage that European options do not.

Intrinsic Value: The difference between the market price of the underlying asset and the strike price (for ITM options).

Time Value: The portion of the option's price that reflects the time remaining until expiration and the potential for the asset price to move. This is the difference between the premium paid and the intrinsic value.

Risks

Trading American style options involves significant risks. It is CRITICAL to understand these before trading:

• Loss of Premium: The maximum loss for an option buyer is the premium paid. If the option expires out of the money, the entire premium is lost.

• Volatility: Options prices are highly sensitive to volatility (the rate at which the price of an asset moves up or down). Increased volatility generally increases option prices, and decreased volatility decreases option prices. Unpredictable volatility can lead to large losses.

• Time Decay: Options lose value as they approach expiration. This is known as time decay (or theta). The closer the option is to expiration, the less time there is for the underlying asset to move, and the lower the option's value.

• Leverage Risk: While leverage can amplify profits, it also amplifies losses. A small adverse price movement can lead to a significant loss, potentially wiping out the entire investment quickly.

• Early Exercise Risk: The risk that the option is exercised before the trader's desired time. This can occur due to dividends, major news releases, or other market events that make exercising the option more attractive. This can create unexpected margin calls and require the trader to immediately provide additional funds.

• Liquidity Risk: Some options contracts, particularly those on less actively traded assets, may have limited liquidity. This means it may be difficult to buy or sell the option quickly at the desired price, especially in times of market stress. This can amplify losses.

History/Examples

American style options have been around for a long time. They are the standard for equity options in the United States and are widely used in other markets.

• Early Origins: Options trading dates back to ancient times, with records of option-like contracts used in ancient Greece and Rome. The modern options market began to develop in the 1970s, with the founding of the Chicago Board Options Exchange (CBOE) in 1973. This provided a centralized marketplace for options trading and standardized contracts.

• Bitcoin Example: Imagine Bitcoin in 2017 when the price soared. An investor who bought a call option at, say, $5,000, could have exercised the option at any point before expiration to buy Bitcoin at $5,000, and then immediately sold the Bitcoin at the market price (which was much higher), generating a significant profit. This flexibility is the key benefit.

• Real Estate Analogy: Think of an American-style option on a property. You get the right to purchase the property at a set price, for a specified period. If the market value of the property increases, you can exercise your option and profit. If the market value declines, you can choose not to exercise, limiting your losses to the option premium.

• Dividend Plays: Consider a stock trading at $100, with a call option at a strike price of $100. If the company announces a large dividend, the option holder might exercise the option to receive the stock and the dividend, even before the expiration date. This would not be possible with a European style option.

• Market Crashes: During market crashes, the ability to exercise a put option early can be crucial. If the market is rapidly declining, the option holder can sell the underlying asset at the strike price, limiting their losses and potentially profiting from the market decline.