European Option: Definition, Types, Versus American Options

What Is a European Option?

A European option is a version of an options contract that limits execution to its expiration date. In other words, if the underlying security similar to a stock has moved in price, an investor wouldn’t have the opportunity to exercise the choice early and take delivery of or sell the shares. As an alternative, the decision or put motion will only happen on the date of option maturity.

One other version of the choices contract is the American option, which may be exercised any time as much as and including the date of expiration. The names of those two versions shouldn’t be confused with the geographic location because the name only signifies the proper of execution.

Key Takeaways

  • A European option is a version of an options contract that limits rights exercise to only the day of expiration.
  • Although American options may be exercised early, it comes at a price since their premiums are sometimes higher than European options.
  • Investors can sell a European option contract back to the market before expiry and receive the online difference between the premiums earned and paid initially.
  • Investors often do not have a alternative of shopping for either the American or the European option and most indexes use European options.
  • The Black-Scholes option model is usually used to value European options.

Understanding a European Option

European options define the timeframe when holders of an options contract may exercise their contract rights. The rights for the choice holder include buying the underlying asset or selling the underlying asset at the required contract price—the strike price. With European options, the holder may only exercise their rights on the day of expiration. As with other versions of options contracts, European options come at an upfront cost—the premium.

It is vital to notice that investors often do not have a alternative of shopping for either the American or the European option. Specific stocks or funds might only be offered in a single version or the opposite, and never in each. Most indexes use European options since it reduces the quantity of accounting needed by the brokerage.

European index options halt trading at business close Thursday before the third Friday of the expiration month. This lapse in trading allows the brokers the flexibility to cost the person assets of the underlying index.

As a result of this process, the settlement price of the choice can often come as a surprise. Stocks or other securities may make drastic moves between the Thursday close and market opening Friday. Also, it could take hours after the market opens Friday for the definite settlement price to publish.

European options normally trade over-the-counter (OTC), while American options often trade on standardized exchanges.

Varieties of European Options

Call

A European call option gives the owner the proper to accumulate the underlying security at expiry. For an investor to benefit from a call option, the stock’s price, at expiry, must be trading high enough above the strike price to cover the associated fee of the choice premium.

Put

A European put option allows the holder to sell the underlying security at expiry. For an investor to benefit from a put option, the stock’s price, at expiry, must be trading far enough below the strike price to cover the associated fee of the choice premium.

Closing a European Option Early

Typically, exercising an option means initializing the rights of the choice in order that a trade is executed on the strike price. Nevertheless, many investors do not like to attend for a European option to run out. As an alternative, investors can sell the choice contract back to the market before its expiration.

Option prices change based on the movement and volatility of the underlying asset and the time until expiration. As a stock price rises and falls, the worth—signified by the premium—of the choice increases and reduces. Investors can unwind their option position early if the present option premium is higher than the premium they initially paid. On this case, the investor would receive the online difference between the 2 premiums.

Closing the choice position before expiration means the trader realizes any gains or losses on the contract itself. An existing call option may very well be sold early if the stock has risen significantly, while a put option may very well be sold if the stock’s price has fallen.

Closing the European option early relies on the prevailing market conditions, the worth of the premium—its intrinsic value—and the choice’s time value—the period of time remaining before a contract’s expiration. If an option is near its expiration, it’s unlikely an investor will get much return for selling the choice early because there’s little time left for the choice to generate profits. On this case, the choice’s value rests on its intrinsic value, an assumed price based on if the contract is in, out, or at the cash (ATM).

European Option vs. American Option

European options can only be exercised on the expiration date, whereas American options may be exercised at any time between the acquisition and expiration dates. In other words, American options allow investors to comprehend a profit as soon because the stock price moves of their favor and enough to greater than offset the premium paid.

Investors will use American options with dividend-paying stocks. In this fashion, they will exercise the choice before an ex-dividend date. The flexibleness of American options allows investors to own an organization’s shares in time to receives a commission a dividend.

Nevertheless, the flexibleness of using an American option comes at a price—a premium to the premium. The increased cost of the choice means investors need the underlying asset to maneuver far enough from the strike price to make the trade return a profit.

Also, if an American option is held to maturity, the investor would have been higher off buying a lower-priced, European version option and paying the lower premium.

Example of a European Option

An investor purchases a July call option on Citigroup Inc. with a $50 strike price. The premium is $5 per contract—100 shares—for a complete cost of $500 ($5 x 100 = $500). At expiration, Citigroup is trading at $75. On this case, the owner of the decision option has the proper to buy the stock at $50—exercise their option—making $25 per share profit. When factoring within the initial premium of $5, the online profit is $20 per share or $2,000 (25 – $5 = $20 x 100 = $2000).

Let’s consider a second scenario whereby Citigroup’s stock price fell to $30 by the point of the decision option’s expiration. Because the stock is trading below the strike of $50, the choice is not exercised and expires worthless. The investor loses the premium of $500 paid on the onset.

The investor can wait until expiry to find out whether the trade is profitable, or they will attempt to sell the decision option back to the market. Whether the premium received for selling the decision option is sufficient to cover the initial $5 paid depends on many conditions, including economic conditions, the corporate’s earnings, the time left until expiration, and the volatility of the stock’s price on the time of the sale.

There is not any guarantee the premium received from selling the decision option before expiry shall be enough to offset the $5 premium paid initially.

Leave a Comment

Copyright © 2024. All Rights Reserved. Finapress | Flytonic Theme by Flytonic.