How american style options affects options prices

American style options are a type of options contract that allows the holder to exercise the option at any time before or on the expiration date.

American style options provide the holder with the flexibility to exercise the option at any point between the purchase date and the expiration date. This contrasts with European style options, which can only be exercised on the expiration date itself. This early exercise feature is a significant characteristic that impacts the pricing of American style options. For a call option, being able to exercise early means that if the underlying asset's price rises significantly, the holder can potentially lock in profits sooner. Similarly, for a put option, if the underlying asset's price falls sharply, the holder can exercise early to protect against further declines or capture immediate gains. The ability to exercise early imbues American style options with a higher theoretical value compared to their European counterparts, assuming all other factors are equal. This is because the early exercise right adds an additional layer of opportunity that European options do not possess. However, exercising an American style option early does not always make financial sense, especially if it means foregoing the remaining time value. Often, selling the option in the open market can yield a better return than exercising, as the sale price would reflect both intrinsic and time value, whereas exercising only captures intrinsic value. The decision to exercise early typically arises when the option is deep in-the-money and the underlying security is not expected to pay a dividend before expiration, or when an arbitrage opportunity could be exploited. This early exercise feature introduces a more complex pricing model, as the potential future exercise decisions must be factored into the option's current value.

Why it matters

- American style options offer greater flexibility to the holder, allowing them to capitalize on favorable price movements in the underlying asset at any time. This immediate action capability can be crucial in volatile markets.
The early exercise feature means American style options typically trade at a higher price than European style options with the same strike price and expiration date. This difference reflects the added value of the early exercise right.
Understanding the nuances of American style options is critical for risk management and strategy development. Traders must weigh the benefits of early exercise against the potential loss of time value, which affects profitability.

Common mistakes

- A common mistake is automatically exercising deep in-the-money options early without considering the remaining time value. Often, selling the option in the open market captures both intrinsic and time value, which typically yields a better return than early exercise.
Traders sometimes fail to account for dividends when holding American style call options. If a significant dividend is announced for the underlying stock, exercising a call option just before the ex-dividend date might be beneficial to capture the dividend, but this needs careful analysis against the lost time value.
Overlooking the impact of interest rates and carrying costs when considering early exercise is another error. These factors can subtly influence the optimal timing for exercising an American style option, particularly for put options.

FAQs

What is the primary difference between American and European style options?

The main distinction is the exercise timing. American style options can be exercised at any point up to and including the expiration date, while European style options can only be exercised on their expiration date.

Why are American style options generally more expensive than European style options?

American style options are typically more expensive because the right to exercise early adds value. This additional flexibility provides more opportunities for the option holder to profit, which is factored into its higher price.

When might it be advantageous to exercise an American style option early?

Early exercise can be advantageous in specific scenarios, such as when a call option is deep in-the-money just before a significant dividend payment, or when a put option is deep in-the-money and there's a strong expectation of a further price decline that you wish to lock in immediately.