American-style option

Definition: A call or put option which can be exercised by its owner any time before it expires.

Example: Emily buys an option to purchase the stock (ie, a call option) of ASO Corporation for $50 per share any time between now and April of next year. At the time Emily buys the option, the price of a share of ASO stock is $45. By January, the stock has risen to $55 per share. Any time she wants, she can exercise her right to buy the shares from the person who sold her the call option. She does this by paying that person $50 per share and receiving the shares in return. She doesn’t have to wait until the expiration date in April, which would be the case if the option was European-style.

Investeach explains: One of the reasons Emily might exercise her option is that she believes the price is headed back down. By buying the shares for $50 and selling them in the market at $55, she locks in a profit of $5 per share. It is this ability to lock in a profit by exercising early that exists with American-style options but not European-style options.

Still, this doesn’t mean that European-style are inferior. Realize that her option has value to other investors beyond the $5 we’ve demonstrated above. This is because it’s only January and her option doesn’t expire until April. There’s a good chance that ASO’s stock will keep rising between January and April. Other investors might be willing to buy her option for, say $6 per share, paying the extra $1 for time left. The break-even point for these investors is the $6 they’re willing to pay for the option plus the $50 per share the option gives them to the right ASO shares for, or $56.  Any value that ASO’s shares have above $56 by April is theirs to keep! For this reason, the better decision for Emily would be to simply sell her option to these investors and make a profit of $6 per share. It is also the reason why European-style options are not a problem. They can be sold before the expiration date to the next investor, allowing the selling investor to lock in his or her profit.

Except for options on stock indexes such as the S&P 500, which may be either style, American investors are unlikely to encounter European-style options.

Riddle me this:

1. What is the difference between an American-style option and a European-style option?
2. How can an investor ‘lock in’ a profit by exercising his option to purchase stock?
3. What is another, more profitable way for an investor to lock in profit on an option he owns?