What is an American Option?

An American option is a financial derivative that grants the holder the right, but not the obligation, to buy or sell a specific asset at a predetermined price on or before a certain date in the future.

Background:

For example, I have a pack of Robert cigarettes, which normally sells for $50. Some people think it will become more expensive because they enjoy it; others think it will decrease in price because they find it unpleasant to smoke. So I create two contracts: one for a call option on the cigarettes and one for a put option. These contracts will expire in one month.

Assumption 1: You believe Robert cigarettes are enjoyable and that the price will rise, so you spend $2 to purchase a call option with a strike price of $50.

One month later: The market price of Robert cigarettes rises to $60. You exercise the call option, buying the cigarettes at $50, and then selling them for $60. Your profit is $10 ($60 – $50), minus the $2 option premium, resulting in a net profit of $8.

If the price doesn’t rise: If the cigarette price remains at $50 or even goes lower, you do not exercise the option, and your loss is just the $2 option premium.

Assumption 2: You believe Robert cigarettes are unpleasant and that the price will fall, so you spend $2 to purchase a put option with a strike price of $50.

One month later: The market price of Robert cigarettes drops to $40. You exercise the put option, selling the cigarettes at $50, and then repurchase them for $40. Your profit is $10 ($50 – $40), minus the $2 option premium, resulting in a net profit of $8.

If the price doesn’t drop: If the cigarette price remains at $50 or even goes higher, you do not exercise the option, and your loss is just the $2 option premium.

Exercising Rights: Option holders have rights, not obligations. Therefore, if the market price is favorable, we can choose to exercise the option; if it is unfavorable, we can choose not to exercise it, thus minimizing losses.

Characteristics of American Options:

Flexibility: As a holder of an American option, you can take action any time during the option contract’s validity, allowing you to exercise the option at the most advantageous moment. Isn’t it exhilarating to have control over your fate?

Improved Risk Management: In the event of unexpected market events, such as a black swan event, you have the ability to protect your investment by exercising your option early.

More Strategy Options: Options can generate profits in any market condition—bullish, bearish, or sideways through various strategies that leverage the versatility of options.

Higher Premiums: Due to the increased flexibility offered by American options, their premiums tend to be higher compared to European options, which can only be exercised at expiration.

Complexity: Options trading can be challenging for beginners due to the need for a solid understanding of market mechanics, risk, and strategy.

Who Should Consider Trading American Options?

1. Experienced Stock Investors
2. Traders with Strong Mindsets
3. Active Short-Term Traders
4. Investors Who Hold Long-Term Stock Positions
5. Lifelong Learners