The Function of American Options

American options  can be  exercised at any time before the expiration date. This is in direct contrast to  European options which can only be exercised at the expiration date. The type of option is not determined by which continent you buy your options on. American options tend to be used more for stocks and bonds. European options tend to be used more for indexes. American options expire on the third Friday of every month. This is because American markets are closed on weekends. Options, and American options in particular, serve certain functions in an in investor portfolio, and in the market as a whole. In an individual portfolio, options are generally used either to speculate, or to hedge risk. 

Using American Options to Speculate

To speculate on a security, you are betting on its movement. While generally you were only able to make a profit off a security if the asset  went up, that changed with options. Options allow you to bet that that the security will go down. You can even make money if the underlying stock does not change in value at all.

Options are considered risky investments. You have to be  able to guess the direction of the stock’s movement, as well as the size and the timing of the movement. You have to also factor in commissions per trade in the calculation. The thing that  makes all these bad odds worth it to so many investors is the leverage gained from options. Options allow you to control at least a hundred shares, with only one instrument. 

Using American Options to Hedge

Hedging your portfolio against risk is like taking out an insurance policy against downturns in the market, or in your portfolio in particular. Hedging strategies can be especially useful for large institutions. If you are bullish  on a certain stock in the long term, you  can invest in it, but still buy puts to hedge against any downsides that you might foresee in the shorter term. 

Options Keep the Market Efficient 

Options have functions beyond speculation and hedging. In the broader sense, they allow for the efficient functioning of the market. If the market thinks that a certain stock is going to fall or rise, options allow for investors to capitalize on this. Therefore gaps in the market are quickly arbitraged, and the market can run more smoothly than it could otherwise.  For an example, you might be very bearish about the market in general, but you think that it might go up very sharply next week. Before options existed, there was no real way to signal one’s more nuanced expectations for the performance of the market through action. Also, options allow investors to shield themselves from unnecessary risk. This means that investors can think in longer horizons for their investments, and this permits a better overall utilization of resources. 

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