American Options: A Detailed Analysis and Application
American options are a type of option that gives the buyer the right to exercise the contract at any time before the expiration date. This distinguishes them from European options, which can only be exercised on a predetermined expiration date. American options are considered more flexible and convenient for managing market risks and implementing strategies. In this article, we will analyze how American options work, their features, advantages and application examples.
What is an American option?
An American option is a contract that gives the buyer the right, but not the obligation:
Call: buy the underlying asset (e.g. stocks, commodities, currency) at a fixed price (strike).
Put: sell the underlying asset at a fixed price.
An important feature of an American option is the ability to exercise at any time before expiration. This provides more opportunities to adapt to changing market conditions.
How does an American option work?
An American option works as follows:
Purchase of the option: The buyer pays a premium (the cost of the option) to the seller.
Exercise of the right: The buyer can exercise the option at any time before the expiration date if it is profitable to do so.
Seller's obligations: The seller is obligated to fulfill the terms of the contract if the buyer decides to exercise their right.
Example:
An investor buys a call option on a company's shares with an exercise price of 100 rubles and a term of 3 months. If the market price of the shares rises to 120 rubles in a month, the investor can exercise the right and buy the shares at 100 rubles, locking in the profit.
Differences between American and European options
Exercise flexibility:
An American option can be exercised at any time, while a European option can only be exercised on the expiration date.
Cost:
Because of their flexibility, American options are usually more expensive, as they provide more opportunities to make a profit.
Suitable assets:
American options are more often used in volatile markets or for assets subject to sharp price changes.
Advantages of American options
Flexibility:
The buyer can exercise the right at any time, which allows you to lock in profits under favorable market conditions.
Risk management:
The possibility of early exercise helps minimize losses in the event of unfavorable price changes.
Speculative potential:
American options are suitable for active trading, since they provide the ability to quickly react to changes in the market situation.
Disadvantages of American options
High premium cost:
Due to flexibility, the price of such options is higher than that of European analogues.
Complexity of management:
It is more difficult for sellers to predict when the buyer will exercise their right, which increases uncertainty.
Examples of American Options Applications
Investing in stocks:
An investor buys a Call option on a stock with a long-term expiration date. If the stock price rises before the expiration date, he can exercise the option early and sell the stock to lock in a profit.
Hedging risks:
A company that buys raw materials buys a Put option on a commodity. If the price of the commodity falls, it can lock in the current price, offsetting losses from the fall in the value of the underlying asset.
Strategies in volatile markets:
Traders use American options to play on short-term price changes, since they can be exercised at any convenient time.
When is it profitable to use American options?
In highly volatile markets:
If the price of the underlying asset changes unpredictably, the ability to exercise early helps to lock in profits or minimize losses.
For active trading:
American options are suitable for traders who are looking for flexibility in implementing their strategies.
For long-term hedging:
Companies and investors use American options to protect themselves from risks throughout the life of the contract.
American options are a powerful tool that, thanks to their flexibility and versatility, allows you to effectively manage risks and take advantage of market opportunities. However, their use requires deep understanding and experience, as the high cost of the premium and the difficulty of predicting the execution can be an obstacle for novice traders.
As the founder of Open Oil Market, I always recommend carefully analyzing the risks and opportunities before using such instruments. American options can be a great addition to your investment portfolio if you understand their features and know how to correctly apply them in your strategies.
Options: Types and their Application for Investors and Traders
