American option

An American option may be exercised at any time up to maturity. Its value is the Snell envelope of its discounted exercise payoff.

For payoff $g(s)=(1+s{)}^{-1}$ and $\alpha =2r/{\sigma }^2\in (0,1)$, the exercise boundary is $b=\alpha /(1-\alpha )$. The value equals $g$ below $b$ and $(1+b{)}^{-1}(s/b{)}^{-\alpha }$ above it. Value matching, smooth fit, and the obstacle problem verify the first down-crossing policy.

If a nonnegative value $V$ dominates the payoff and $a=rV-{\mathcal{L}}_{r}V\ge 0$, delta holdings $V\prime (S)$ combined with a reserve satisfying $dD=(rD+a(S))dt$ give a self-financing portfolio of wealth $V(S)+D$. The reserve retains the surplus instead of consuming it, so the wealth dominates the payoff at every exercise time.

An American put has exercise payoff $(K-S_n{)}^{+}$. In a finite binomial market, backward option pricing compares that payoff with the discounted risk-neutral continuation value at every node.