Why Are American Options More Valuable?
American options are the version of options contracts that allows the holder to exercise the option right at any time before or during the expiration day. Another version of options contracts is European options. Such an option contract allows holders to execute option right only on the expiration day.
So, this article is all about why are American options more valuable. The main reason is, American options allow the investor to capture profit when they see the price movement is in their favor. The difference between the two is only the rights of execution.
Pros and Cons of American Options
American options are more valuable, so let’s have a look at some of the pros and cons of American options.
Pros Of American Options
Cons Of American Options
You have the right to exercise your options anytime.
You will have to pay more for premiums.
It allows you to exercise right before an ex-dividend date.
You can’t use American options for index option contracts.
You can use profits for the next trade.
You may miss out on additional optional appreciation.
American Option Style vs. European Option Style
Options traders have to deal with many more factors than stock traders do. Almost all the investors are familiar with call and put options, but most of them are not familiar with trading styles. So, the options are divided into two main styles, such as American options style and European Options Style. Both of these options styles have lots of things in common. Both these styles shared the following characteristics:
- In both styles, the strike price is set.
- Both options styles have set expiration dates.
- Both styles have similar structures for their ticker symbol.
- Both these styles are traded on exchanges.
However, a significant difference between the two is execution or exercising them.
How Are American Options More Valuable?
In American options, the timeframe is specified in which option owner can exercise his rights. These rights allow the option holder to buy or sell options based on the call or put. An option holder can exercise rights based on the strike price either before or on the expiration date. American options are costly and worthy than European options because you can exercise your rights whenever you see market movement is in your favor. However, in European options, you can only exercise your rights on the expiration date irrespective of the strike prices.
So, in simple words, investors have the freedom to exercise their options at any point during the specified life of the asset or contract. When you exercise options early, it carries added cost or premium. You can exercise your weekly American option on the Friday of each week because weekly American options expire on Friday. On the other hand, you can exercise the monthly American option on the third Friday of each month. So, exchange-traded options on the individual stocks are American, and options on indexes are mostly European style.
American Call and Put Options
An American call option gives the holder the right to purchase the underlying security of assets or stock at any day within the life of the contract. It means option holder has the right to purchase stock anytime before or during the expiration date. However, the strike price will remain the same throughout the contract that was specified.
Let’s take an example if an investor purchases a call option in March, and the option has the expiry date of the end of December of the same year. It means the option holder has the right to exercise his option any time within this period. American options are valuable because investors don’t have to wait for the asset’s price to go beyond the strike price to exercise their options. A slight disadvantage of American call options is you have to pay added or premium costs, but you can factor these costs in the overall profitability of the trade.
Similarly, American put options allow investors to exercise their right before or on the expiry of an option. It offers the freedom to sell the underlying asset when the strike price falls below the asset’s price.
When To Exercise American Options Early
Most of the time, American option holders didn’t practice the right of early exercising of the asset. It is more cost-effective to exercise options early instead of holding them until expiry. When the values of stock prices go higher, it increases the value of the call option, and at the same time value of premium also increases. If the value of the current premium is higher than those that are paid during the onset, a trader can sell their option back to the market. In this way, a trader or investor can earn the net difference between the two premiums and deducting any fees from the broker.
However, there are lots of opportunities when the asset’s prices go beyond the option’s strike price, so that you can exercise your options early. When the asset price is below the strike price, you can easily cash your right of selling at any time. Another benefit of exercising early is investor gets the strike price immediately. It allows the investors to invest this money in other trade to make more money.
Why are American options more valuable? A simple answer to this question is that they give you the right to exercise your asset anytime before or on the expiry date. On the other hand, you can’t do this in a European option style. In European style, you can only exercise your right on the day of expiration. Whenever you see the strike prices are higher than the asset price, you can use the call option to make profits. On the other hand, when strike prices are lower than the asset price, you can use the put option to sell the asset and make profits.
Selling your options anytime means that you can reinvest in other trades. On the other hand, you can’t do this with European options because you will have to wait for the expiration date. In American options, when you exercise your right early, the premium costs will be higher. Still, American options are more valuable than Europeans.
Sky Hoon. Read Full Bio
Website Owner, Twitter-er
He has been trading since 2008. He started this blog to share the journey about option trading. He dabbled in stocks, bitcoin, ethereum (in Celsius Network), ETF (lazy Dollar Cost Averaging) and also built websites for fun. He used this as a platform to share my experiences and mistakes in trading, especially options which I just picked up.