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American Style Options: Summary
American Style Options - Definition
An option contract that may be exercised at any time between the date of purchase and the expiration date.
American Style Options - Introduction
American Style Option, or American Option, is one of two options exercise styles in options trading. The other being the European Style Option. The main difference between American Style Options and European Style Options is the fact that American Style Options allow the holder to exercise the option at anytime prior to expiration while the former allows exercise only upon expiration. In fact, most exchanged traded options are American style options.
So, what is the benefits of being able to exercise an option prior to expiration? How are American Style Options priced? We shall cover these and more in this tutorial.
Two Main Exercise Styles
The two main options exercise styles are American Style exercise and European Style exercise. These names has nothing to do with where the options are traded. In fact, most exchanged traded options all over the world are American Style Options. American Style exercise allows an option to be exercised prior to expiration while European style exercise allows exercise only during expiration. This may look like a small difference but has led to differences in pricing methods and opens up new options trading strategies. So, what is the benefit of being able to exercise an option early prior to expiration?
American Style Options - Why Exercise Early?
When an option is exercised, all existing extrinsic value remaining in the option evaporates.
Indeed, exercising an option sacrifices all remaining extrinsic value remaining in the option. This is why most options traders simply sell their options positions in order to take profit instead of exercising the option.
In that case, what is the value of American Style Options in options trading if there are no benefits in exercising early? In fact, American Style Options are priced higher in terms of extrinsic value than European Options due to this benefit of being able to exercise early as you will learn below. So why pay more for no benefits?
Well, the good news is, there is one situation in which an early exercise would have allowed the holder to make more profits than selling a profitable call option and it is for this purpose that American Style Options are created; Dividends!
As we all know, holders of call options are not entitled to dividends on dividend paying stocks. However, as long as you own the stocks during ex-dividend day, you are entitled to the dividends. This opens up a new tactical consideration for American Style Call Options. If the dividends to be received exceeds the extrinsic value remaining in the option, then the holder would make a higher profit by exercising the call options early, sacrificing the lower extrinsic value for the higher dividends to be received.
So, why should we exercise put options early?
The only situation which makes sense for early exercise of put options is on stocks of companies that are going bankrupt. Being able to exercise early allows you to sell your shares before the shares get delisted and into the OTC market. Without a put option, you may not be able to find a buyer for your stocks at all.
American Style Options Pricing
American Style Options are generally more expensive than European Style options due to this added benefit of being able to exercise the options early. However, you might notice that the Black-Scholes Model is widely used for pricing of American Style Options but the actual traded prices are usually higher than the theoretical values generated by the model. This is because the Black-Scholes options pricing model was designed with European Style Options in mind, not American Style Options. So far, there is no generally accepted method (true during time of writing at 2010) of pricing American Style Options even though many methods using regression, least squares, monte carlo or binomial has been proposed. So far, market forces of demand through implied volatility seems to be the major determinant of the extrinsic value of an American Style Option.
Even though the pricing of American Style Options is different from European Style Options and certainly a lot more involved, there is one situation when American Style options have exactly the same value as an European Style Option and that is during expiration where there are no more extrinsic value remaining in both styles of options.
How Do We Tell If An Option Is American Style?
All equities options traded in the US market are American Style Options and are physically settled options. Basically, only cash settled options are European style options. You can check if an index option is American Style or European style by going to OIC's Product Specification Page.