Question

the value of American calls (as most traded options are in American type) will decline if the underlying stocks pay dividends, and therefore theoretically, the investors should sell an American call before dividends payment since the investors can buy it back with a lower price after dividends payment. However, in practice, it may not be a wise idea to sell your American call before the dividend payments and purchase back after the dividend payments. In other words, if you want to create a trading strategy to capture arbitrage profits by shorting a call immediately before the dividend payments and immediately closing out this short position by longing a call right after the dividend payments, there are some issues that may cause a failure of this strategy.

Answer 1

What Is an American Option?

An American option is a version of an options contract that allows holders to exercise the option rights at any time before and including the day of expiration. Another version or style of option execution is the European option that allows execution only on the day of expiration.

An American style option allows investors to capture profit as soon as the stock price moves favorably. The names American and European have nothing to do with the geographic location but only apply to the style of rights execution.

American Options Explained

American options outline the timeframe when the option holder can exercise their option contract rights. These rights allow the holder to buy or sell—depending on if the option is a call or put—the underlying asset, at the set strike price on or before the predetermined expiration date. Since investors have the freedom to exercise their options at any point during the life of the contract, American style options are more valuable than the limited European options. However, the ability to exercise early carries an added premium or cost.

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.

The majority of exchange-traded options on single stocks are American, while options on indexes tend to be European style.

American Call and Put Options

A call option gives the holder the right to demand delivery of the underlying security or stock on any day within the contract period. This feature includes any day leading up to and the day of expiration. As with all options, the holder does not have an obligation to receive the share if they choose not to exercise their right. The strike price remains the same specified value throughout the contract.

If an investor purchased a call option for a company in March with an expiration date at the end of December of the same year, they would have the right to exercise the call option at any time up until its expiration date. American options are helpful since investors don't have to wait to exercise the option when the asset's price rises above the strike price. However, American style options carry a premium—an upfront cost—that investors pay and which must be factored into the overall profitability of the trade.

American put options also allow the execution at any point up to and including the expiration date. This ability gives the holder the freedom to demand the buyer takes delivery of the underlying asset whenever the price falls below the specified strike price.

When to Exercise Early

In many instances, holders of American style options do not utilize the early exercise provision, since it's usually more cost-effective to either hold the contract until expiration or exit the position by selling the option contract outright. In other words, as a stock price rises, the value of a call option increases as does its premium. Traders can sell their option back to the options market if the current premium is higher than the initial premium paid at the onset. The trader would earn the net difference between the two premiums minus any fees or commissions from the broker.

However, there are times when options are typically exercised early. Deep-in-the-money call options—where the asset's price is well above the option's strike price—will usually be exercised early. Puts can also be deep-in-the-money when the price is significantly below the strike price. In most cases, deep prices are those that are more than $10 in-the-money.

Early execution can also happen leading up to the date a stock goes ex-dividend. Ex-dividend is the cutoff date by which shareholders must own the stock to receive the next scheduled dividend payment. Option holders do not receive dividend payments. So, many investors will exercise their options before the ex-dividend date to capture the gains from a profitable position and get paid the dividend.

The reason for the early exercise has to do with the cost of carry or the opportunity cost associated with not investing the gains from the put option. When a put is exercised, investors are paid the strike price immediately. As a result, the proceeds can be invested in another security to earn interest.

However, the drawback to exercising puts is that the investor would miss out on any dividends since exercising would sell the shares. Also, the option itself might continue to increase in value if held to expiry, and exercising early might lead to missing out on any further gains.

Pros

• Ability to exercise at any time

• Allows exercise before an ex-dividend date

• Allows profits to be put back to work

Cons

• Charges a higher premium

• Not available for index option contracts

• May miss out on additional option appreciation

Real World Example of an American Option

An investor purchased an American style call option for Apple Inc. (AAPL) in March with an expiration date at the end of December in the same year. The premium is $5 per option contract—one contract is 100 shares ($5 x 100 = $500)—and the strike price on the option is $100. Following the purchase, the stock price rose to $150 per share.

The investor exercises the call option on Apple before expiration buying 100 shares of Apple for $100 per share. In other words, the investor would be long 100 shares of Apple at the $100 strike price. The investor immediately sells the shares for the current market price of $150 and pockets the $50 per share profit. The investor earned $5,000 in total minus the premium of $500 for buying the option and any broker commissions.

Let's say an investor believes shares of Facebook Inc. (FB) will decline in the upcoming months. The investor purchases an American style July put option in January, which expires in September of the same year. The option premium is $3 per contract (100 x $3 = $300) and the strike price is $150.

Facebook's stock price falls to $90 per share, and the investor exercises the put option and is short 100 shares of Facebook at the $150 strike price. The transaction effectively has the investor buying 100 shares of Facebook at the current $90 price and immediately selling those shares at the $150 strike price. However, in practice, the net difference is settled, and the investor earns a $60 profit on the option contract, which equates to $6,000 minus the premium of $300 and any broker commissions.