An American option is a type of financial derivative that gives the holder the right but not the obligation to buy or sell an underlying asset at a predetermined price on or before a specified future date.
Background:
Let’s say I have a pack of James cigarettes that normally sells for $50 a pack. Some people think it's great and believe the price will go up while others think it's bad and believe the price will drop. I then create two contracts: one is a call option (betting the price will rise) and the other is a put option (betting the price will fall) both expiring in one month.
Scenario 1: You think James cigarettes are great and the price will rise so you pay $2 for a call option with a strike price of $50.
One month later: The market price for James cigarettes rises to $60. You exercise the call option, buy the cigarettes for $50 and sell them for $60. Your profit is $10 (60 - 50) minus the $2 option fee, leaving you with a net profit of $8.
If the price doesn’t rise: If the price stays at $50 or goes lower, you don’t exercise the option and your loss is just the $2 option fee.
Scenario 2: You think James cigarettes are bad and the price will drop, so you pay $2 for a put option with a strike price of $50.
One month later: The market price for James cigarettes falls to $40. You exercise the put option, sell the cigarettes for $50 and buy them back for $40. Your profit is $10 (50 - 40), minus the $2 option fee leaving you with a net profit of $8.
If the price doesn’t drop: If the price stays at $50 or goes higher, you don’t exercise the option and your loss is just the $2 option fee.
Exercise Rights: Option holders have the right, but not the obligation, to exercise their options. Therefore, if the market price is favorable to us we can choose to exercise the option. If it’s unfavorable, we can choose not to exercise minimizing our losses.
Features of American Options:
Highly Flexible: As the holder of an American option, you can act at any time during the contract’s validity, allowing you to exercise the option at the most advantageous moment. Doesn’t it feel great to have control over your own destiny?
Better Risk Management: When a black swan event occurs, you have the ability to protect your investment.
More Strategy Options: Whether the market is bullish, bearish or volatile, options can still be profitable.
Higher Premiums: Due to the greater flexibility provided by American options, the premium is generally higher than that of European options with similar conditions.
More Complex: Options can be somewhat unfriendly to beginners.
Who Should Trade American Options?
1. Graduates of stock investing
2. People with a strong mindset
3. Active short-term traders
4. Those who enjoy holding large amounts of stock for the long term
5. People who love to learn
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