What does american style options mean in option trading?

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 significant flexibility to the holder compared to other option types. The defining characteristic of an American style option is the ability to exercise the contract at any point from the purchase date up to and including the expiration date. This contrasts with European style options, which can only be exercised on the expiration date itself. This early exercise feature can be particularly valuable for call options where the underlying stock might pay a dividend, or for put options where a sudden downturn in the underlying asset's price creates an opportunity to lock in profits or mitigate losses immediately. The decision to exercise an American style option early is complex and depends on factors like the current price of the underlying asset, the time value remaining on the option, implied volatility, interest rates, and any dividends expected. For call options, early exercise might be considered if a significant dividend is about to be paid, as exercising the option allows the holder to own the stock and receive the dividend. However, exercising early means forfeiting any remaining time value of the option. For put options, early exercise might occur if the underlying asset's price has fallen substantially, and the holder wishes to realize the maximum intrinsic value without waiting for expiration, though again, the loss of time value must be weighed against the benefits. Because of this added flexibility, American style options typically trade at a higher premium than European style options with the same strike price and expiration date, reflecting the increased value of the early exercise privilege. Understanding when and if to exercise an American style option early is a critical skill for options traders.

Why it matters

- American style options offer greater flexibility to the option holder, allowing them to capitalize on market movements or dividend payments at any time before expiration. This can be a key advantage for managing risk or seizing opportunities.
The ability to exercise an American style option early can be strategic, particularly when anticipating dividends for call options or wishing to lock in profits rapidly for put options. This flexibility impacts how traders approach their positions.
Investors frequently use American style options for various strategies, including hedging existing stock portfolios or speculating on future price movements. Their early exercise feature makes them versatile tools in many trading scenarios.

Common mistakes

- A common mistake is exercising an American style call option too early, especially if the dividend is small or if there is significant time value remaining. Exercising early means you forfeit the remaining time value, which can be a substantial loss.
Many traders might immediately exercise an in-the-money put option without considering the time value that would be lost. Often, it is more profitable to sell the put option on the open market rather than exercising it early, as selling allows you to capture both intrinsic and remaining time value.
Overlooking the costs associated with early exercise, such as commissions for buying or selling the underlying shares, is another mistake. These costs can erode potential gains, making what seems like a good move less attractive.

FAQs

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

The primary difference lies in the exercise window. American style options can be exercised at any time up to and including the expiration date, while European style options can only be exercised on the expiration date itself.

Why would someone choose to exercise an American style option early?

Early exercise might be chosen to capture an upcoming dividend when holding a call option, or to lock in profits or mitigate losses on a put option if the underlying asset's price has moved significantly in a favorable direction, especially if the time value is minimal.

Do American style options cost more than European style options?

Generally, yes. Due to the added flexibility of early exercise, American style options typically command a higher premium than European style options with the same underlying asset, strike price, and expiration date.