An American call option means buying the underlying shares at the strike price. An American put option means selling the underlying shares at the strike price. For example, you may buy one call option for stock XYZ with a strike price of $50 on January 1. The option expires on June 1. You can choose to exercise the option at any time between January 1 and June 1. Call options let you buy shares at the strike price, so if the price of XYZ rises above $50 at any point between January 1 and June 1, you have the option to exercise the contract, buy the shares below market value, and sell them for a profit.
Risk of Early Exercise
The risk of an American option is that you may exercise the option too early, losing out on potential profit. For American call options, that could be the case for a stock where the price goes up after the option is exercised. For example, if the price of XYZ rises to $51, you may exercise the option and earn a small profit. If it later rises to $60, you could have earned more had you waited to exercise the option.
An American Option vs. a European Option
The primary difference between American options and European options is in when the option holder has the right to exercise the contract.
Pros and Cons of an American Option
Pros Explained
More flexibility for options holders: Options holders have more flexibility in when they exercise the contract, which gives them more opportunity to exercise it when stock prices will make exercising profitable.Traded on exchanges rather than over-the-counter: American options are widely traded on exchanges rather than over-the-counter, which means the market for American options is larger and more liquid.
Cons Explained
Less predictability for options sellers: Investors who sell American options need to be prepared for the options holder to exercise it before the expiration date, which makes selling these options unpredictable.Options buyers may miss out on potential profits: Options holders who exercise the option prior to expiration may find they could have exercised it for greater profit if they’d held the option for longer.
What It Means for Individual Investors
Individual investors need to keep the type of option they’re buying and selling in mind. Options buyers will typically want to buy American options as they offer more flexibility. If you’re selling American options, take note that the option can be exercised at any point before its expiration date. You need to be ready to fulfill the contract in the event the holder chooses to exercise early.
