American Call and Put Options
The investing term American option refers to contracts that give the investor the right to buy, or sell, a security at a specific price on or before a certain date. An American call option provides the investor with the right to purchase a security, while a put option provides the investor with a right to sell it.
ExplanationAn American option allows the holder to exercise their right at any time prior to the contract's maturity date, while European options can only be exercised on the maturity date. Most securities traded on an exchange today are American options. These contracts will specify at least four variables:
- Underlying Asset: common and preferred stock, commodities, interest rates, as well as derivatives.
- Premium: the price paid when an option is purchased or sold.
- Strike Price: identifies the price at which the holder of the contract has a right to sell (put option) or buy (call option) the underlying asset.
- Maturity Date: also referred to as the expiry date; the option no longer has any value if not exercised before this date.
These financial instruments come in two basic forms:
- Call Options: also referred to as calls, this contract gives the holder the right to purchase the security at the strike price before the maturity date.
- Put Option: also referred to as puts, this contract gives the holder the right to sell the security at the strike price before the maturity date.
Options provide their holder with certain rights, which are not obligations. For example, a call option gives the holder the right to purchase securities at the strike price. The holder is not required to complete this transaction. Investors can also short (sell) a call option, giving the buyer of the call option the right to purchase the asset at the strike price. The seller of the call option is compensated by the premium paid by the buyer, regardless if the buyer exercises their rights.
The common stock of Company A is currently trading at $25.00 per share. Haley believes the value of Company A's stock is going to increase, so she buys a call option for 100 shares of stock with a strike price of $25.00, expiring in 180 days. Over the next six months, the price of Company A's stock increases to $28.00 per share, and Haley's call option is "in-the-money." Haley exercises her right to purchase the stock for 100 shares x $25.00, or $2,500, and immediately sells the stock back into the market for $28.00 per share, or $2,800.