What is an American Option

An American option is an option that can be exercised anytime during its life, and not only at its expiration. American options allow holders to exercise the option at any time prior to and including its maturity date, thus increasing the value of the option to the holder relative to otherwise identical European options, which can only be exercised at maturity. The majority of exchange-traded options on single stocks are American, while options on indexes tend to be European style.

If you are short an American options contract that has been exercised, it is said that you have been assigned the exercised stock. The process of assignment by execution is carried out on a random basis.

Note that the name of this option style has nothing to do with the geographic location.

BREAKING DOWN American Option

American options allow the holder to buy or sell a specified underlying asset, on or before a predetermined expiration date. Since investors have the freedom to exercise their American options at any point during the life of the contract, they are more valuable than European options, which can only be exercised at maturity. In other words, the ability to exercise early carries an added premium. The last day to exercise a weekly American option is normally on the Friday of the week in which the option contract expires. Conversely, the last day to exercise a monthly American option is normally the third Friday of the month.

American Call Option

Consider this example: If an investor purchased a call option on Apple Inc. in March, expiring in December of the current year, the investor would have the right to exercise the call option at any time up until its expiration date. If the call option on Apple Inc. had been a European option, the investor would only be able exercise the option at the expiry date in December. If, hypothetically, that share price became most optimal for exercise in August, the investor would still have to wait until December to exercise the call option, when it could be out-of-the-money and virtually worthless.

Assume the investor exercised the call option on Apple prior to the expiration date. The investor would be long 100 shares of Apple at the specified strike price. Conversely, if the investor waited until the expiration date and Apple's stock price closed at least 1 cent above the strike price, the investor would be automatically exercised and long 100 shares.

American Put Option

In contrast to an American call option, the holder of an American put option has the right to exercise the option at any point in time until its expiration date. Assume an investor purchased a Facebook Inc. July put option in January. The investor has the right to exercise the put option on or before the option's expiration date. If the investor decides to exercise the put option, the investor would be short 100 shares of Facebook at the predetermined strike price.

When to Exercise Early

Most of the time, holders of American style options do not utilize the early exercise provision, since it is usually more cost-effective to either hold on to the option until expiration, or exit the position through selling the contract outright. There are two common situations, however, that usually do warrant early exercise. For calls, deeply in-the-money options (with deltas at or near 100) will be exercised the day before a stock goes ex-dividend. This allows the owner of the calls, which at 100 delta behave essentially the same as the underlying stock, to receive the cash dividend that would not be paid out to the options contracts.

The other situation is to exercise early deeply in-the-money puts (with deltas at or near 100). The reason for this has to do with the cost of carry. When you exercise a put, you get paid the strike price immediately, so you can invest that money and earn some interest, compared with only exercising at expiry. The benefit to exercising early is that extra interest. The cost is the remaining time value of the option, along with any dividend payments you miss.