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December 23, 2010
American Option
An American option does not refer to options contracts sold in the United States nor is it a stock option on an American company. An American option is a style of option. An American option can be an option on stocks, commodities, or futures that can be exercised on any trading day during the life of the options contract. Other options styles include Bermuda options, European options, and barrier options. Two general terms are vanilla options and exotic options. These refer respectively to options with simple terms and those with complex terms. Unlike an American option a European style option can only be exercised at expiration. A Bermuda style option is a bit more flexible in that the contract will specify a number of dates besides expiration during which a contract may be executed. It is through the use of technical analysis tools such as Candlestick pattern formations that traders can anticipate and take advantage of options price changes.

The options trader may well ask what is the point of buying calls or buying puts or selling calls or selling puts via an American option versus, for example, a European style option. The advantage of the American option is its flexibility. Because American style options can be executed on any day during the contract period allow traders to take advantage of market inefficiency that may only persist for a brief period of time during a volatile market whether this is because of a market rally or market reversal. Because it is often market volatility that leads to profits in trading stocks or trading options the American option style can be a distinct advantage.

An American option can be either “vanilla” or “exotic.” The American style only refers to the ability to execute the option and not how complicated the contract is. A barrier option may or may not be American style in that the barrier aspect of the option may preclude its execution. In the case of the more exotic options the American option aspect may be a minor consideration if the list of terms and conditions associated with the option is excessive. For the options trader interested in using tools like Candlestick analysis to follows the stock market and profit from predicting changes in stock prices an exotic option will be of little interest. These options are typically written for very specific situations and are commonly tailor made for the parties involved in the options transaction. Fundamental analysis and technical analysis may be less of an issue in exotic options as the terms may be so specific that other market considerations don’t really matter.

The point of trading buying options is to purchase the opportunity to buy (calls) or sell (puts) stock as movement in stock price dictates. Buying puts or calls on a stock does not confer an obligation to the buyer but requires the seller (options writer) to sell (calls) or buy (puts) if the buyer executes the contract. In the case of an American option this means that the options writer may be called upon to come up with the cash to satisfy the contract at any time during the contract period. On the other hand a writer of a European style options contract will only need to buy or sell stock to satisfy a contact upon the expiration date. In either case the savvy trader will track stock price movement with Candlestick charts in order to optimize profits.

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