American Options 

American Options are an important component of financial markets that provides various strategies for investors to hedge, speculate, or manage risk through trading in options. The American option is considered special because of its wide usage and flexibility. The blog focusses on what an American option is, how an American option works, types, historical background, and examples, mainly keeping in view markets outside India. 

What is an American Option? 

An American option is a type of derivative contract that provides the holder with the right but not the obligation to buy or sell an underlying asset at a set price called the strike price at any time before or on its expiration date. Its flexibility sets it apart from the European Option, which has an exercise deadline at expiration. 

An American option can be written on a common stock, bond, commodity, index, or currency. American options trade in markets is the most common instrument investors use to speculate. Their exercisability at any time before expiration makes them more valuable and versatile than their European cousins. 

Understanding American Options 

The underlying nature is the basic knowledge needed to appreciate the value of American options. American options usually have a value above European options. because of the added flexibility that makes up the intrinsic value and time value. The intrinsic value reflects the difference between the underlying asset and exercise prices. A positive value arises when the current price exceeds the exercise price for a call option. The time value represents that the option can get costlier with the passage of time before the expiration. The time value for a greater period to expiration will be greater, largely reflecting the increased number of chances for the underlying to move in a favorable direction. 

Pricing the American options is always more complicated and generally requires models like the Binomial Option Pricing Model, which accounts for early exercise, thus adding complexity to European options. One of the main reasons for early exercise is dividend payments. If the underlying were going to be a stock that is paying dividends, the holder could exercise an option before the ex-dividend date so that they have a right to the dividend while holding the right to the upside from the stock. This is a significant factor for call options. 

Types of American Options 

American options are categorised according to the nature of the underlying security and the purpose served. Types of American options include: 

1. Stock Options: These are the most common American options, giving the holder the right to buy or sell shares of a specific stock. They are widely traded on massive exchanges like the New York Stock Exchange (NYSE) and NASDAQ. 

1. Index Options: The underlying assets would be a stock index, like the S&P 500 or the NASDAQ 100. While less popular, they still excite some interest among investors seeking a hedge on general market movement rather than individual stock movement. 

1. Commodity Options: It involves American options on commodities, such as gold, oil, and agricultural products. It is used to hedge the price fluctuations in commodities for companies involved in their businesses. 

1. Currency Options: These are options on currency pairs that allow investors to take a broad view or take a speculative view of currency movements. Multinationals and forex traders widely use them. 

1. Bond Options: These are options to buy or sell a bond at a certain price. Fixed-income investors use bond options to control the risk related to interest rates. 

Historical Background and Development 

The fundamentals of options trading have a long history. The contemporary form of American options was developed in the United States during the 1970s. The foundation of the Chicago Board Options Exchange in 1973 heralded a new era in trading options, and this was the first exchange ever to list standardised and regulated options contracts. 

The introduction of American options effectively made this new range of flexibility available, something that many investors had been yearning for, and with good reason. This flexibility was particularly attractive in the highly volatile financial markets of the 1970s, with investors seeking to offer good risk management while at the same time benefiting from market movements. 

One of the most important events in American option history comes in the development of the Black-Scholes model in 1973 by Fischer Black and Myron Scholes. Over the years, American options have also seen growing popularity and complexity. Electronic trading and the evolution of financial derivatives have been working to involve a larger pool in the investment of the American options market. 

American Options Examples 

1. Stock Option Illustration: If an investor purchases a call option on shares of Apple Inc. having a strike price of US$150 and with an expiration date three months ahead, then in case the Apple stock price rises to US$170 any time before the expiry date, he may exercise the right to call and purchase the shares at US$ 150 and immediately capture the 

profit.  Or else, the investor can sell the option in the market for a premium that would be equivalent to that higher intrinsic value. 

1. Dividend Capture Strategy: An investor with a call option on a stock that pays dividends can exercise the option in the days leading up to the ex-dividend date, acquire the shares, and be eligible for the soon-to-be-announced dividend. In the end, the investor captures the dividend payment and is left with a stock in hopes of further profit. 

1. Index Option Example: An institutional investor is worried that some market decline is in store and buys a put option on the S&P 500 index. If the market loses a lot, the index can be sold at the strike price in this option to compensate for some losses in their more general portfolio. 

Conclusion 

American options form an important constituent of the financial markets and offer versatility with wide application in speculation and generating income. There are many tools available that make it easier to address market complexities. Options trading can only become truly successful if mechanics, pricing, and strategic use are understood. The American option will remain at the center as the markets keep changing. It has proved their worth as vital tools in ensuring risk management and exploiting opportunities. 

Frequently Asked Questions