American Options: What They Are and How They Work
American options are a style of options contracts that allow you to exercise an option up until the expiration date. That’s in contrast to European options, which allow you to exercise the contract only on the expiration date, never before.
There are pros and cons to American options contracts. Sometimes, it’s to the advantage of the investor to exercise the contract early. Other times, it’s better to hold on until the expiration date or even sell the contract back on the market early.
In this article, we will look at what American options are and how they work. Plus, we’ll discuss when you should use them. By the end, you should have a better understanding of how to factor them into your options trading strategy.
What Are American Options?
American options are a style of options that allow you to exercise an options contract any time up until their expiration. This gives you flexibility with your options trading strategy.
One of the biggest advantages of these options is that you can exercise the contracts as soon as they are in the money or whenever the price moves in a beneficial direction.
Let’s say you have a call option with a strike price of $10, and today, the underlying stock trades at $15. With an American option, you don’t have to wait to execute and possibly lose out on profits. You can execute the trade immediately and cash in on the $5 spread.
Call options can be American- or European-style. This is true of put options as well. In addition, the terms “American” and “European” have nothing to do with the countries of origin or geography. They simply indicate when you are allowed to exercise the option.
More Features of American-Style Options
In general, American options are more valuable than European-style options because of the built-in flexibility they give you as to when you may exercise them.
However, this additional value for the contract is not free. Because American contracts tend to be more valuable, they come at a higher premium, which is the price you pay to buy the contract.
The majority of American-style contracts are on individual stocks rather than on indexes. For example, you might buy an American-style call on Coca-Cola (NYSE: KO).
On the other hand, European-style contracts often apply to indexes, such as the S&P 500. Perhaps you would want to buy an American-style put on an S&P 500 Index fund if you think the market will go down in the short term.
American calls and puts can also be divided into weekly options and monthly options. These terms relate to the expiration date. The last day to exercise a weekly option is usually the Friday of the expiration week. Generally, the last day to exercise a monthly American option is the third Friday of the month it expires.
When to Use Them
Now that you know what American options are, how can you find out the best times to use them? And what strategies should you employ in doing so?
Remember, just because you can exercise these contracts before the expiration date doesn’t mean you have to, or that it’s always the best strategy to do so.
Often, it makes sense to exercise your contract when your call or put option is deep in the money. “Deep in the money” usually means a favorable difference of at least $10 between the strike price and the underlying asset price.
When an option is deep in the money, exercising a contract early is a useful way to capture the gains. If you wait, there is a risk that the contract will be less in the money or even out of the money altogether.
When a contract is not deep in the money, it will often make sense to hold on to the option until expiration or even sell the contract back on the open market. But this will depend on a few other factors.
American options can be quite useful when it comes to dividends. As you know, many stocks pay dividends to shareholders, and these dividends are a part of your return on the investment.
Unfortunately, options contracts themselves do not entitle you to dividends paid by the underlying asset.
Say you own a European-style call option on Coca-Cola. The stock pays dividends on November 1, but the contract doesn’t expire until November 21. Since you must wait until expiration to acquire the underlying assets, you will not receive this dividend payment.
However, with American-style contracts, you can take advantage of upcoming dividend payments. The date by which you must own a stock in order to be entitled to dividends is known as the ex-dividend date.
So if you exercise your call option and purchase shares of Coca-Cola before its ex-dividend date and continue to hold, you will be entitled to receive the dividends paid out on those shares of stock.
This is part of the flexibility that owning American-style contracts gives you that you don’t get with European-style options. That’s also part of why you pay a higher premium for American-style options.
Cost of Carry
Another thing you need to be aware of when it comes to American options is the cost of carry. When you have an option contract, such as a put option, there is an opportunity cost to be aware of.
If the contract is in the money and you don’t exercise the contract, you’re giving up gains that could be realized immediately. Say you have a put option on Coca-Cola for a strike price of $60 and Coke is trading at $50. Perhaps you’re bearish on Coca-Cola and you think it will continue to drop in price by the expiration date of the contract. This can be beneficial. However, there is an opportunity cost. This opportunity cost is the cost of carry.
By not exercising the contract, you don’t have access to the immediate funds you could earn by exercising the contract. In this case, you’re giving up the $10 spread you’d earn by buying shares of Coca-Cola and exercising the contract.
Not only that, but you’re giving up your ability to invest the $10 you earn on such a trade in another security. If you did, you could be earning additional interest on that $10. This is why, when holding an American option through its expiration date, you should make sure to account for the cost of carry.
Concluding Thoughts on American Options
American options can be more useful and profitable than their European counterparts when used correctly in a trading strategy. And though these advantages come at a premium, they are often worth it.
If you’re interested in learning more about options trading, make sure to sign up for our free e-letter Trade of the Day. In this e-letter, you’ll learn much more about trading stocks and options and discover more strategies to help you make money.
Finally, if you found this article on American options helpful, make sure to watch for the next article in this series on options trading, about “European options.
About Brian M. Reiser
Brian M. Reiser has a Bachelor of Science degree in Management with a concentration in finance from the School of Management at Binghamton University.
He also holds a B.A. in philosophy from Columbia University and an M.A. in philosophy from the University of South Florida.
His primary interests at Investment U include personal finance, debt, tech stocks and more.