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What is an American Option?

An American option is a type of financial derivative contract that gives the holder (buyer) the right, but not the obligation, to buy or sell an underlying asset at a predetermined price, known as the strike price, at any time before or on the expiration date of the option contract. The key distinction of an American option is that it can be exercised at any point during its lifespan, whereas a European option can only be exercised at the expiration date.

The underlying asset of an American option can vary and includes things like stocks, bonds, commodities, or indexes. The option contract specifies whether it is a call option (the right to buy) or a put option (the right to sell) the underlying asset.

The flexibility of an American option to be exercised at any time prior to its expiration date adds value compared to a European option. This is because the option holder can choose to exercise the option when it is most advantageous, depending on market conditions or the price movement of the underlying asset.

However, the flexibility of early exercise also means that the pricing and valuation of American options are more complex than European options. The value of an American option is influenced by various factors, including the price of the underlying asset, the time remaining until expiration, the volatility of the underlying asset, interest rates, and any dividends or distributions associated with the underlying asset.

Options trading involves risks and complexities, and it’s important to understand the terms and conditions of the specific option contract, as well as seek professional advice or do thorough research before engaging in options trading.