American options and European options describe different patterns of exercising options. American options can be exercised at any time before expiration, while European options can only be exercised at expiration. These terms were used by American economist Paul Samuelson to distinguish between the two different types of options and do not refer to the geographical origins of the options.
What is the difference between American options and European options?
While the main difference between European and American options is when they can be exercised, this is not the only way in which they differ.
Underlying Assets
Options are contracts that grant the buyer the right but not the obligation to buy or sell a financial product, such as a stock, at a specified time called the “expiration date” at a specified price. Options for selling are called “puts”, while options for buying are called “calls”.
Options are called “derivatives” because their value is derived from an underlying asset, which is another financial product such as a stock, an exchange-traded fund (ETF), or a commodity like gold.
Note: Stock options and ETF options are generally of the American option type and are more common. Generally, but not always, index options are of the European option type.
Exercising Options
Holders of American options can exercise their right to buy or sell a stock or an ETF at any time before the contract’s expiration date. Meanwhile, European contracts can only be exercised on the expiration date.
Settlement
When exercising American options, the stock or ETF is actually transferred from the seller to the buyer. When exercising European options, only cash is transferred because the value of the option depends on changes in a financial index rather than the price of a stock, ETF, or commodity.
Taxation
The taxation of American options and European options can vary based on the holding period and the complexity of your transactions. Generally, the holding period of options determines whether the option receives short-term or long-term capital gains treatment.
Some European index options may qualify for more favorable tax treatment even if held for less than one year. Under Section 1256 of the U.S. tax code, some index options may be taxed at 60% as long-term capital gains and 40% as short-term capital gains.
Example of American Options and European Options
In most cases, investors do not have the right to choose the option style. Individual stocks and ETFs are of the American type, while indices, with some exceptions, are of the European type. However, there is one strategy where investors can make a decision on which style is more attractive to them.
Investors who wish to buy or sell options based on the S&P 500 index have two choices: they can buy options on ETFs that hold all the individual securities in the index, such as the SPDR S&P 500 ETF (symbol SPY); or they can invest in something like S&P 500 index options (symbol SPX) on the Chicago Board Options Exchange (CBOE).
Here’s a quick comparison between the two styles:
SPDR Options S&P 500 Index Options
Underlying Asset: Exchange-Traded Fund S&P 500 Index
Style: American European
Dividend Distribution Potential: Yes No
SPX options are available in a variety of products. Some allow for global trading hours (S&P 500 index options do not allow this), and there is a product that offers a small size or 1/10 of the size.
S&P 100 index options (OEX) offer options of both American and European types.
Conclusion
The difference between American and European options is when they can be exercised, the underlying assets they are used for, and the applicable taxation. Most often, the option style is predetermined. Options can be very rewarding, but they carry a high level of risk. Be sure to understand how they work and what the consequences of each move can be before investing. And of course, do the necessary research, study the fundamentals, and form strong opinions on the expected moves of the underlying securities before entering into any options contracts.
Note:
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Sources:
– Robert C. Merton. “Samuelson Interview.”
– Michael D. Mullaney. “The Complete Guide to Option Strategies – Advanced and Basic Strategies on Stocks, ETFs, Indexes, and Stock Index Futures,” Page 419. Wiley & Sons Inc., 2009.
– Fidelity. “Index Options vs. ETF Options Webinar Series With CBOE,” Page 11.
– IRS. “Topic No. 409 Capital Gains and Losses.”
– Charles Schwab. “How Are Options Taxed?”
– CBOE. “S&P 500 Index Options.”
– Nasdaq. “SPY Option Chain.”
– CBOE. “S&P 500 Index Options Fact Sheet.”
– CBOE. “S&P 100 Index Options.”
Source: https://www.thebalancemoney.com/american-vs-european-options-what-s-the-difference-5270440
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