An option gives you the right, but not the obligation, to buy or sell an asset at a particular price on a predetermined date. There are many kinds of options, including American and European options.
So what is an American option? This type of option that allows you to exercise your right at any time before the expiry period. This is unlike the European option, which will enable you to exercise your right only on the day of expiration.
There are two types; one is the American call option, and another is the put option. An American call option gives you the right to buy a particular asset, while the put option gives you the right to sell the asset at a specific price.
American option explained
Let’s see how this type of option would work with the help of an example (this would be an example of an American call option). Let’s assume that you are expecting the share price of Company X to go up in the future. So you purchase 1,000 options of Company X at a strike price of Rs 35 each. A few days before the expiration date, the share price of Company X hits Rs 50. However, you expect this price to drop soon, and you want to book profits right away. Since you have these, you would be able to do that and book profits and make Rs 15,000. Otherwise, you may have to wait for the expiration date, and by that time there are chances that the prices would have dropped.
An American style option thus gives you the freedom to exercise your right immediately and make the best of an unfolding situation. This works for a put option as well. If you purchase 1,000 put options of Company X at a strike price of Rs 35 each, and the share price of Company X hits Rs 25 soon after. You will be able immediately exercise your right and make profits of Rs 10,000!
Premium on American style options
However, there is a price to be paid for this kind of privilege offered by an American option. When you enter into an option, you have to pay a premium to your broker, which is eventually passed on to the seller of the option or `writer’. This premium varies from asset to asset and depends on a host of other factors too. It is generally a small percentage of the underlying asset.
In the case of these options, you will have to pay higher premiums. So American option pricing will affect how much you can leverage. The higher premiums will mean lower leverage, and so the chances of making higher profits will thus be more moderate.
When to buy American options
An American style option certainly gives you more flexibility. However, your choice might be quite limited in this matter, because the kind of option available could depend on the exchange and the asset. In India, for example, you can get American call options for stocks. However, American options are unavailable for index and currency options. So, in this case, you will have no choice but to go with whatever’s on offer.
Pros and cons of American options
As we have seen, an American style option does offer the flexibility to exercise your right at any time. However, there could be a temptation to jump the gun and exercise your right at the first instance of prices moving in your favour. In that case, you will stand to lose if prices move higher (in the case of a call option ) or lower (in the case of a put option). American options are also not available for index options, so they’re not of much use there.