American Style Options
Options contracts can all be put into one of two distinct categories – American style and European style. These categories having nothing to do with part of the world the contracts are bought and sold in, but relate to the actual terms of the contract.
An options contract that is American style allows the holder of that contract to exercise their option to buy or sell the underlying security at any time prior to the expiration date. Most options traded on the exchanges are American style, and they tend to be far more popular. On this page we provide further information about them such as how they are priced and the advantages they offer.
- What are American Style Options?
- Advantages of American Style Options
- Buying & Selling American Style Options
What Are American Style Options?
Options can be categorized in a variety of ways and some of these are relatively straightforward. For example a call is one that gives the holder the right to buy a specified asset, while a put grants the holder the right to sell a specified asset. Options can be categorized by what underlying security is used, or how they are sold. There are also a few of them that are classed as exotics, such as barrier options or look back options, and are customized and more complex.
All of these types are financial contracts consisting of two parties – the writer and the holder. The writer of a contract is providing the holder with the right to buy or sell a specific underlying security at a specific strike price. The holder pays the necessary asking price in order to buy the contract and get the right to buy or sell the relevant security. These contracts all contain a fixed expiration date at which point the contract terminates if the holder has not exercised their option.
Every single options contract can be classified as either American style or European style. The difference between these two styles may not seem significant, but it's actually a very important difference. The key characteristic of American style options is that the terms of these contracts allow the holder to exercise at any time during the contract.
The majority of the more commonly traded options or those that are traded on the exchanges by brokers and easily accessible to members of the public fall into the American style category. For the purposes of most trading strategies, the flexibility that they offer is essential. This additional flexibility does come at a price though, as American style contracts do tend to be more expensively priced than European style contracts.
American Style Options Pricing
When options are listed for sale on the exchanges, they are listed with an ask price that is the price you must pay to purchase them. The price is made up of two components: intrinsic value and extrinsic value. Contracts are not specifically broken down into these components when listed on the exchanges, but you do need to understand what these two terms mean and the differences between the two.
Intrinsic value is the term used for any profit that is essentially already built into the contract. Let’s look at a hypothetical example of a call contract for sale. A call gives the holder the right to buy a specific security at a fixed strike price, so let’s say the security is stock in Company X and the strike price is $50. If shares in Company X are trading at $55, then a call with a strike price would effectively contain $5 worth of profit, as you could exercise your option to buy the stock at $50 and sell it immediately for $55.
This is known as an "in the money" contract. The $5 profit that already existed in the contract is the intrinsic value. If the strike price was equal to the current trading price (an at the money contract) or above the current trading price (an out of the money contract) then there is no built in profit and therefore no intrinsic value.
Extrinsic value is the part of the price over and above any intrinsic value and basically represents the actual cost of owning the contract. The intrinsic value is a true, inherent value as the profit is actually there to be realized. The extrinsic value is the additional cost for any benefit that you might get from owning the contract. For example, the extrinsic value of the call in the example above would be based on the possibility and likelihood of shares in the company increasing in price during the term of the contract.
The extrinsic value of American style options tends to be higher than European style options, because of the flexibility of being able to exercise at any time, to be able to take advantage of price fluctuations in the underlying security. As the expiration date of a contract gets nearer, the extrinsic value declines due to the decreasing amount of time left to benefit from any such fluctuations.
Advantages of American Style Options
The real advantage of American style contracts over European style contracts is the flexibility that they offer. When you own American style contracts you have the right to exercise at any point up until the expiration date of the contract. This in itself gives you a number of benefits that can help you maximize your returns from trading.
If you own calls where the underlying security is company stock, and that company stock is quite volatile and jumping down in price, then you can choose to exercise at a precise time when you feel the company stock is at its peak. This enables you to use your own judgment and cash in on your investment at the time that you feel is right, rather than waiting until the expiration date and hoping that you can make a profit at that point. In practice, you would probably choose to sell your contracts rather than exercise, but the principle remains the same.
Another benefit as a result of this flexibility relates to dividends. If you own stock in a dividend paying company then you will receive a regular pay-out, typically annually, based on company profits and the number of shares you own. Owning calls in such company stock would give you the right to purchase company shares, but you wouldn’t be entitled to any dividends.
However, you could choose to exercise to buy those shares at dividend time – meaning you would be entitled to dividends. It would only make sense to do this if the expected dividends were higher than any extrinsic value in the contracts you were exercising, but this is another example of how the flexibility of American style options can be used to your advantage.
Buying & Selling American Style Options
Most American style options are exchange traded contracts that are bought and sold on the exchanges. In order trade them yourself you will need the services of a broker to execute transactions on your behalf. The easiest way to buy and sell these contracts is to sign up for an account with an online broker.