American-Style Options

No. You don't own the stock, so you can't collect a dividend.

Suppose you purchase a long call option. At the point of purchase, you're essentially long on the stock and hoping that the price of the underlying reaches the strike and exceeds it. If the option gets "in the money," then you're in business and can make a profit. But what options do you have to recognize that profit?

You got it! You'd sell the option, collect the gain, and be able to invest the proceeds in the risk-free rate, so the put option needs to price in this opportunity for the put holder. For American-style options, the binomial tree requires working backward to identify if early exercise is optimal at each node, especially for put options.

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No. That doesn't help generate a guaranteed return necessary to make the exercise opportunity valuable.

That's it! Both options would work; you could sell the call or exercise the option. But there's a catch: exercising the option is only a possibility if this is an American-style option. For European options, the value of the option can only be realized by selling it (or buying it, if it's sold short), because it can't be exercised until the exercise date.

For American-style options, the value of that opportunity to exercise the stock is typically worth something, but the value varies between calls and puts. Imagine you went long a call contract on Ample Connect (AC). As AC's price rose, your call option benefits because the spot price gets closer to the strike price. Think about what would happen if AC's stock rose rapidly, and your call option was deep in the money (really valuable). In that case, you'd probably sell it since it still has time remaining before expiration. Why is that?

No. The call option would be worth more than the stock, so you'd probably sell the option.

Not quite. It's not the exercise opportunity that makes selling the call the right decision.

You got it! The time value remaining means that the call value would be greater than the value of exercising AC stock. You'd probably sell the call to gain that value. The exercising opportunity for calls really doesn't add much value in general. But puts are a different story.

Again, think of owning a deep-in-the-money put. AC fell, and the put is worth a lot. In this case, that exercise opportunity is valuable. Why might that be?

Sell the call

Exercise the option

The AC stock price is worth more than the value of the call

The time value makes the call worth more than the AC stock price

The exercise value makes the call worth more than the AC stock price

You can collect a dividend from AC

You can sell the put and receive interest

You can sell the put and invest back in AC

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