Definition and Examples of European Options
A European option is a type of option contract that limits investors to exercising the option only on its expiration date. The option holder has the right to exercise the option but is not obligated to do so. They may also choose to let the option expire without exercising it.
If the option is a call option, the holder can exercise it to buy shares at the strike price. If the option is a put option, the holder can exercise it to sell shares.
For example, on January 1, if an investor bought a European put option for XYZ Company with an expiration date of June 30 and a strike price of $50, they would not be able to exercise this option until June 30. If XYZ’s price drops below $50, it would be profitable to buy the shares in the market and exercise the option to sell them at $50, making a profit. However, the option holder must wait until June 30 to decide whether to exercise the contract or not.
Note: In order to profit from a European option before the expiration date, the option holder needs to sell the option to someone else for a price higher than what they paid.
European Option vs. American Option
American options are the main alternative to European options. The main difference between them is when the option holder can exercise the contract.
European Option American Option
Can only be exercised on expiration date Can be exercised at any time before expiration date
Less flexible meaning they generally have lower value and incur lower fees compared to American options More flexible meaning they generally have higher value and incur higher fees compared to European options
Some index options available in the U.S. are European options Most U.S. stock options are American options
Typically traded in the over-the-counter (OTC) market Traded on exchanges
While a European option holder can exercise it only on the expiration date, an American option can be exercised at any time while it is being sold and until it expires.
This makes American options more flexible. The contract holder can choose to exercise the option immediately when it becomes profitable, which means they do not have to worry about the movement of the underlying security’s price making it unprofitable by the expiration date.
Note: Generally, American options command higher fees due to their flexibility. Option holders benefit from the ability to exercise the option at their discretion.
Advantages and Disadvantages of European Options
Advantages
More predictable for option sellers Options are cheaper to buy
Disadvantages
Usually sold in the OTC market Less flexible for option buyers
Outlined Advantages
More predictable for option sellers. Since European option holders can only exercise on the expiration date, option sellers do not have to worry about being prepared to exercise options early. Options are cheaper to buy. European options are generally cheaper than American options, giving buyers the ability to purchase more contracts for the same amount of money.
Outlined Disadvantages
Usually sold in the OTC market. European options typically are not traded on exchanges, meaning they are less liquid and may take longer to buy and sell compared to American options. Less flexibility for option buyers. If you hold a European option, you have less flexibility regarding exercising the option, meaning you may miss a profitable opportunity that you could have taken advantage of had you purchased an American option.
What
What does this mean for individual investors?
When buying and selling options, investors need to pay attention to the type of option they are dealing with. European options are more predictable, which can be beneficial for option sellers. However, American options offer the flexibility of early exercise, which can be advantageous for option buyers.
Note: It is almost never advisable to exercise an American option early on a non-dividend-paying stock. This means that the flexibility for which the investor paid a higher value is not really utilized. This can make a case for choosing the European option instead.
However, buyers should keep in mind the restrictions on when they can exercise the contract as it can affect their ability to profitability from the option.
Takeaway
European options can only be exercised at expiration. European options tend to be less valuable than more flexible option contracts. Option buyers can profit before expiration only by selling the contract to someone else.
Sources
Peter Moles and Nicholas Terry. “Handbook of International Financial Terms,” Page 13. Oxford University Press, 1997.
FINRA. “Options A-Z: The Basics to the Greeks.” Accessed Aug. 6, 2021.
Neil C Schofield. “Equity Derivatives Corporate and Institutional Applications,” Palgrave Macmillan UK, 2017. Accessed Aug. 6, 2021.
Philippe Jorion. “Financial Risk Manager Handbook,” Fourth Edition, John Wiley & Sons Inc., 2007. Accessed Aug. 6, 2021.
Source: https://www.thebalancemoney.com/european-option-5196347
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