American vs. European Options: An Overview

American and European options have similar characteristics however the differences are vital. As an example, owners of American-style options may exercise at any time before the choice expires. Then again, European-style options may exercise only at expiration.

Although most equity options are American style options, many broad-based equity indices, including the S&P 500, have actively traded European-style options.

American Options

Options are contracts that derive their value from an underlying asset or investment. Options give the owner the correct to purchase or sell the underlying asset (akin to a stock), at a set price (called the strike price), on or before a particular expiration date in the longer term. A call option gives the owner the correct to purchase a stock, for instance, while a put option gives the owner the correct to sell the stock. The up-front fee (called the premium) is what the investor pays to buy the choice.

Typically, stock options are for a single stock, while index options are based on a basket of equities that may represent the equity market as a complete or a portion of the market, akin to a particular industry. A stock option will be exercised before its expiration date (if it’s American-style), while an option on an index can only be exercised on its expiry (if it’s European-style). Nevertheless, investors can unwind an option position by selling it before its expiry, including European-style options, though there might be a gain or loss between the premiums paid and received.

All optionable stocks and exchange-traded funds (ETFs) have American-style options while only a couple of broad-based indices have American-style options. American index options stop trading on the close of business on the third Friday of the expiration month, with a couple of exceptions. For instance, some options are quarterlies, which trade until the last trading day of the calendar quarter, while weeklies stop trading on Wednesday or Friday of the required week.

The settlement price is the official closing price for the expiration period, establishing which options are in the cash and subject to auto-exercise. Any option that is in the cash by one cent or more on the expiration date is routinely exercised unless the choice owner specifically requests their broker to not exercise. The settlement price for the underlying asset (stock, ETF, or index) with American-style options is the regular closing price or the last trade before the market closes on the third Friday. After-hours trades don’t count when determining the settlement price.

With American-style options, there are seldom surprises. If the stock is trading at $40.12 a couple of minutes before the closing bell on expiration Friday, you’ll be able to anticipate that 40 puts will expire worthlessly and that 40 calls will probably be in the cash. If you might have a brief position within the 40 call and don’t need to be hit with an exercise notice, you’ll be able to repurchase those calls. The settlement price may change and 40 calls may move out of the cash, nevertheless it’s unlikely the worth will change significantly in the previous couple of minutes.

European Options

European index options stop trading sooner or later earlier, on the close of business on the Thursday preceding the third Friday of the expiration month.

It is just not as easy to discover the settlement price for European-style options. The truth is, the settlement price is just not published until hours after the market opens. The European settlement price is calculated as follows:

• On the third Friday of the month, the opening price for every stock within the index is decided. Individual stocks open at different times, with a few of these opening prices available at 9:30 a.m. ET while others are determined a couple of minutes later. 
• The underlying index price is calculated as if all stocks were trading at their respective opening prices at the identical time. This is just not a real-world price because you can’t have a look at the published index and assume the settlement price is close in value.

Exercise Rights

Once you own an option, you control the correct to exercise. Occasionally, it could be helpful to exercise an option before it expires, to gather a dividend, for instance, nevertheless it’s seldom vital. Dividends are money payments paid to shareholders by firms as a reward to investors. Once you sell an American-style option, you sell the choice without owning it and are assigned an exercise notice before expiration and are short the stock.

The one time an early task carries significant risk occurs with American-style cash-settled index options, suggesting the simplest option to avoid early-exercise risk is to avoid American options. If you receive an task notice, you will need to repurchase that option on the previous night’s intrinsic value, placing you at serious risk if the market undergoes a major move.

Money Settlement

It’s advantageous to all parties when options are settled in money:

• No shares exchange hands.
• You haven’t got to fret about rebuilding a fancy stock portfolio since you don’t lose energetic positions if assigned an exercise notice on calls you wrote, as in covered call writing or a collar strategy.
• The choice owner receives the money value and the choice seller pays the money value of the choice. That money value is the same as the choice’s intrinsic value. If the choice is out of the cash, it expires worthless and has zero money value.

These cash-settled options are almost all the time European-style and task only occurs at expiration, thus the choice’s money value is decided by the settlement price.

Settlement Price

The settlement price is usually a surprise with European-style options because, when the market opens for trading on the morning of the third Friday, a major price change may occur from the previous night’s close. This does not occur on a regular basis nevertheless it happens often enough to show the apparently low-risk strategy of holding the position overnight into of venture.

Here’s the scenario faced by European option traders Thursday afternoon on the day before expiration:

• If the choice is nearly worthless, holding on and hoping for a miracle is just not a foul idea. Owners of low-priced options, value a couple of nickels or less, have earned a whole lot or 1000’s of dollars when the market shifted higher or lower on Friday morning. Nevertheless, these options expire worthless more often than not.
• In the event you own an option that has a major value, you might have a call to make. The settlement price could make the choice worthless or double its value. Do you must roll the dice? It’s a risk-based decision that individual investors must make for themselves.

When short the choice, you face a distinct challenge:

• When short an out-of-the-money option, covering is a clever move. With American-style options, you see the stock approaching the strike and might spend a nickel or two to cover. But with European options, there aren’t any warnings. Any out-of-the-money option can move 10 or 20 points into the cash, costing $1,000 to $2,000 per contract when forced to pay the settlement price. It’s just not definitely worth the risk.