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American call options

Unlike European option, an American options can be exercised at any point before it expires. In this video we walk through the process of exercising an American call option. Created by Sal Khan.

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  • leaf green style avatar for user Oli5679
    I don't see why there's a difference between American and European call options in a liquid market.

    If I had an option allowing me to buy a $50 stock for $60 for 30 days and the price increased to $80 in 15 days, excercising the option on day 15 would give me $20. But the option would have a market value of say $25 because of the probability that the stock will rise further. This means no sane person would excercise an option before expiry rather than sell it on? Am I wrong?
    (35 votes)
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    • blobby green style avatar for user brian.hood
      Oli you're actually correct. An American call option on a non-dividend paying stock SHOULD NEVER be exercised prior to expiration (Derivatives Markets, 2nd Ed. pg 294). What is always more profitable is what you said, to instead sell your option with time (T-t) left, where T is expiration date and t is time you would exercise, receiving both the difference in spot and strike value (S(t) - K) and option premium.
      (20 votes)
  • blobby green style avatar for user Guy Brown
    Are options also used for people with limited initial capital who wish to maximise future returns through owning more shares later on when they can exercise them??

    Also slightly off topic - Why are options considered derivatives?

    Thanks in advance!
    (4 votes)
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    • blobby green style avatar for user newell.starks
      Yes, they do provide an excellent way to leverage your capital. More importantly they provide a way to hedge your downside risk which is virtually impossible to do absent options.
      The rate of change of the slope of a curve is the first derivative (Calculus). Generally speaking, derivatives is a term of art used by financiers to describe anything that derives it's value from any other underlying (including another derivative). Virtually all of these instruments are expressed mathematically, often with advanced math. I do not know, but reasonably speculate that someone along the way simply recognized that derivative was a good, mathematically descriptive term. You will often hear folks say that they are "stripping" risk off of the underlying assets - essentially that means creating a new derivative and selling it (that is basically how the CDOs (Credit Default Swaps) got created. Remember, there are always two sides to every trade - so while you think you made a smart move, the person (or computer more likely) on the other side thinks you didn't!
      (15 votes)
  • blobby green style avatar for user Viktoriya Ivanova
    so the call is the right to buy and put is the right to sell. None of them are obligation. Let say the stock price is $50. I buy a call $60 that expires in 90 days. well In 2 months the stock price goes up to $100. If I decide to exercise my call, can the stock owner refuse to sell it to me for $60? Or once the call/put is written, the writer of it is required to comply if the purchaser of the option decides to exercise it?
    (5 votes)
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  • leaf orange style avatar for user Kwon,Soon Ai
    How does the stike price set?
    For example, the above example shows that the strike price is $60. How did the price, $60 set up in the first place?
    (5 votes)
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    • male robot hal style avatar for user Andrew M
      Typically there are "market makers" who decide what options they want to make a market in. They try to offer instruments that a lot of people will want to buy and sell. They don't want to have illiquid options markets. If you are a big enough investor, you can probably get a brokerage firm to offer just about any strike price and expiration you want.
      (7 votes)
  • purple pi purple style avatar for user Jeremy John Clayton
    So who does the money go to for the option? Does the company that issues the stock offer the option or is there a broker that does this for a fee. It seems like a lot of risk for the broker... well, if that's the case ( I don't think it is).
    (5 votes)
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    • blobby green style avatar for user Will.H.Ashman
      The option could be written by anyone who has the financial backing to meet their obligation or be bought by anyone who also has the financial backing to meet their obligation. It all depends on who is in the money at the time the option is exercised. For American options this can be before or on the options expiration date and for European options they can only be exercised on the expiration date.
      (4 votes)
  • female robot amelia style avatar for user Vg
    Is there ever any benefit to buying a European stock option vs an American one? I can't seem to think of any reason why someone would give up on the flexibility of buying at any point before expiration.
    (4 votes)
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    • ohnoes default style avatar for user Tejas
      One reason is that European stock options tend to be more volatile, so that attracts short-term traders. Another reason is that although it is better to own American options, it is still better to sell and short European options. Perhaps the most important reason is that they tend to be cheaper.
      (6 votes)
  • blobby green style avatar for user essam salah
    for the example in that vedio i have some quistions
    1- at what basis the price of the option determined ( 5 dollars )?and who determine it ??
    2- now the price is 50 and i buy an option with strike price 60 >> is the strike price is the price where i need the stock to go higher than it for me to start profiting ?? and who determine it ?? and at what basis he determine it ?? and what happen if the price at the end of the month was (55 or 60 or 65 )
    3- the option period is 1 month lets say the stock go to 80 at the first week can i close the contract and collect my profit or i must wait to the end of the month ??

    4- a good idea have come to my mind after i watch this video (( i am very beginner at option ))
    let's say i am a stock trader and i buy a stock at 50 dollar hoping it to go to 90 and at this case i will earn 40 but as we all know there is nothing 100% sure in trading and if the price go to 10 i well be losing 40 dollar
    so why i don't protect my self >> you will ask how
    i will till you the idea : i will buy the stock at 50 and at the same time sell an option
    if the price go up to 90 i will earn 40 -5 ( cost of the option )=35 instead of 40 ( not bad )
    but if the stock go to 10 i will not lose 40 because the the lose in from the stock will be combinsated from the profit of the option
    is this idea is good or silly ?or is there is things that i don't understand or know
    (3 votes)
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    • male robot hal style avatar for user Andrew M
      Option strike prices are offered across a wide range, for most optionable stocks. There are brokers and others who make a market in the options and will try to offer the "flavors" that buyers want.
      The strike price of a call optiion is what you would have to pay to buy the stock if you decide to exercise the option. If you have a strike price of 60, then if you want to exercise your option, you pay $60 and hand over your option, and you get the stock. Obviously you would not want to do that if the stock is selling for $50. If you have bought a call with a strike price of $60, you need the stock to be above $60 at the time of expiration, or the option is worthless. Of course you can also sell the option any time before expiration.
      (5 votes)
  • spunky sam blue style avatar for user Ricardo Mantecon
    So if I buy an option, even though the shares' price is $80each, in that moment I can buy the "real" stock for only $60each? Or would I have to pay $80?
    (2 votes)
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  • aqualine ultimate style avatar for user Rachel Phipps
    I have never heard about different kinds of options before ( - ). European options sound like they don't give you as much flexibility since you have to wait until a set time to exercise the right.
    (2 votes)
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  • old spice man blue style avatar for user Galba
    Is there typically a minimum number of shares for an option contract? I am assuming probably 100 shares so in this case you would pay $500 total (100 shares at $5/share)?
    (3 votes)
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Video transcript

Let's say you think very highly of Company ABCD, and you're convinced that the stock price will go up from its current trading price of $50 per share. You could do two things. You could either just buy the stock for $50, and hope that the price goes up. Or-- and I made this price up-- you could go to an options exchange and for the price of $5, you could buy the option to buy this stock over the next month. It expires in one month. Usually it will be a specific date, but I'm just saying one month from the date that you buy the option. And it gives you the option to buy the stock for $60 a share. The type of option that I've just described is called an American option. And it can be compared to a European option. An American option allows you to exercise the option-- to actually buy the stock-- any time from the time you have the option until the expiration. On a European option, you only have the option-- you could only exercise it-- on the expiration. But we'll just focus on the American. Now let's think about the different outcomes depending on what the stock does. So let's say the stock actually does do what you think it does. Let's say it goes up, and then it goes down. Let's say that you're really good at calling stock price tops. And then right over here-- let's take the two scenarios. Let's take the scenario where you bought the stock, and then you sell the stock. So you bought at $50 and then over here right at the top-- you're just a perfect market caller-- you were able to sell the stock at $80. So let's just think about the different profit scenarios. So here we have an end price of $80 per share. If you had bought the stock for $50, and now sold it at $80, you will have a profit of $30. Now let's think about if instead of buying the stock, you bought the option today. So if you bought the option, same thing. When the stock goes up to here, you'll say, oh, I think that's the top for the stock. Let me exercise my option. So I'm going to exercise my option, which gives me the right to buy the stock at $60 a share. So you're going to buy it at $60 a share, right over here. And then you can immediately sell it for $80 a share. So you can make $20 on that transaction. But of course, you paid $5 for the option itself. So you make $20 on the difference between 80 and 60, but you had to pay 5. So you have a $15 profit. So there it says, hey, look. Maybe I was better off buying the stock. And even there I would say, look, to buy the stock, you had to put $50 of capital at risk. To buy the option, you only had to put $5 of capital at risk. And to see that, imagine the negative scenario, where instead of the stock doing that, let's say the stock just completely plummets after you buy it. And it goes all the way down to $20. Now in the situation with the stock-- let's say right over there you just had enough. You just say, I want to sell the stock. So this is an end price of $20. In that situation, you bought for $50, sell for $20. You will lose $30. But in the option scenario, this entire time that it was plummeting, you'll say, I just won't exercise the option. The option is out of the money. It makes no sense for me to exercise it. So you just won't exercise the option. So you'll only lose the price that you paid for the option. You'll only lose your $5.