American Option
Quick Answer
An American Option, or American-style option, is an options contract that allows its holder to exercise the option before or on its expiration date, subject to the contract and market rules. A call holder may exercise the right to buy the underlying asset, while a put holder may exercise the right to sell it.
How does an American Option work?
An option gives its buyer a right rather than an obligation. A call option gives the holder the right to buy the underlying asset at the option's strike price, while a put option gives the holder the right to sell it at that price.
The defining feature of an American-style option is early exercise. The holder can generally choose to exercise the contract on an eligible business day before expiration rather than having to wait until the expiration date. Cboe defines American style as allowing the holder to exercise the contract before or on expiration.
When an American-style option is exercised, the holder invokes the contractual right. For listed equity options cleared through OCC, the exercise notice is submitted through the holder's brokerage firm. OCC then assigns the exercise to a clearing member, which in turn allocates the obligation to an option writer according to its procedures.
Because the holder can exercise early, a trader who has written, or sold, an American-style option may also face assignment before expiration.
Key features of American Options
Several characteristics distinguish American-style options:
Early exercise is permitted: The holder can generally exercise before expiration, subject to applicable cut-off times and contract rules.
Calls and puts grant different rights: Exercising a call invokes the right to buy the underlying asset, while exercising a put invokes the right to sell it.
Assignment can occur early: A writer of an American-style option can be assigned before expiration if a holder chooses to exercise.
Exercise style is separate from settlement method: American-style options may be physically settled or cash settled depending on the specific contract. OCC notes that index options can be designated American- or European-style and may use cash settlement.
Many listed equity options use American-style exercise: OCC states that standard listed equity options under its specifications are American-style and can be exercised on any business day through expiration.
Simple American Option example
Suppose a trader owns an American-style call option with:
Strike price: $50
Expiration date: 30 September
Before expiration, the underlying asset rises to $60.
Because the option is American-style, the holder has the contractual right to exercise before 30 September, subject to the applicable exercise procedures.
If exercised, the call grants the holder the right to buy the underlying asset at the $50 strike price, even though the simplified example assumes a current market price of $60.
This does not mean exercising early is automatically the most advantageous choice. The option may still contain time value, and selling or closing the option may produce a different economic result.
This example is illustrative only. It does not include premiums, transaction costs, dividends, taxes, liquidity, settlement details or other factors and does not represent actual FxGrow trading conditions.
Potential benefits and uses
The early-exercise feature gives an American-style option holder additional flexibility compared with an otherwise similar option that can be exercised only at expiration.
It may allow the holder to:
exercise a contractual right before expiration when circumstances make doing so relevant;
respond to changes involving the underlying asset before the expiration date;
decide between exercising, closing the option in the market or continuing to hold it, where those alternatives are available.
For some equity call options, dividends can be relevant to early-exercise decisions because the holder of an unexercised call does not own the underlying shares and therefore is not entitled to their dividends. Cboe notes that this can create circumstances in which a call holder may consider exercising before an ex-dividend date.
Risks, limitations and common misconceptions
A common misconception is that an American option is linked specifically to an American company or US market. The term describes the exercise style, not the nationality of the underlying asset.
Another misconception is that an American-style option should always be exercised as soon as it becomes profitable or in the money. Early exercise may give up remaining time value, so exercising and selling the option are not economically identical decisions.
The early-exercise right also creates assignment risk for option writers. An investor with a short American-style position can potentially receive an assignment before expiration and must then meet the obligations of the contract.
American-style exercise also does not guarantee a profitable outcome. Option values can be affected by the underlying asset price, time remaining until expiration, volatility, interest rates, dividends and other factors. Cboe documentation identifies these variables as relevant influences on option premiums.