European-Style Option

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European Option

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 such as a stock has moved in price an investor would not be able to exercise the option early and take delivery of or sell the shares. Instead, the call or put action will only take place on the date of option maturity.

Another version of the options contract is the American options, which can be exercised any time up to and including the date of expiration. The names of these two versions should not be confused with the geographic location as the name only signifies the right of execution.

European Options Explained

European options define the timeframe when holders of an options contract may exercise their contract rights. The rights for the option holder include buying the underlying asset or selling the underlying asset at the specified 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 important to note that investors usually don’t have a choice of buying either the American or the European option. Specific stocks or funds might only be offered in one version or the other, and not in both. Also, most indexes use European options because it reduces the amount of accounting needed by the brokerage. Many brokers use the Black Scholes model (BSM) to value European options.

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 ability to price the individual assets of the underlying index. Due to this process, the settlement price of the option can often come as a surprise. Stocks or other securities may make drastic moves between the Thursday close and market opening Friday. Also, it may 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 usually trade on standardized exchanges.

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 can be exercised early, it comes at a price since their premiums are often higher than European options.
  • Investors can sell a European option contract back to the market before expiry and receive the net difference between the premiums earned and paid initially.

European Calls and Puts

A European call option gives the owner the liberty to acquire the underlying security at expiry. A call option buyer is bullish on the underlying asset and expects the market price to trade higher than the call option’s strike price before or by the expiration date. The option’s strike price is the price at which the contract converts to shares of the underlying asset. For an investor to profit from a call option, the stock’s price, at expiry, has to be trading high enough above the strike price to cover the cost of the option premium.

A European put option allows the holder to sell the underlying security at expiry. A put option buyer is bearish on the underlying asset and expects the market price to trade lower than the option’s strike price before or by the contract’s expiration. For an investor to profit from a put option, the stock’s price, at expiry, has to be trading far enough below the strike price to cover the cost of the option premium.

Closing a European Option Early

Typically, exercising an option means initializing the rights of the option so that a trade is executed at the strike price. However, many investors don’t like to wait for a European option to expire. Instead, investors can sell the option 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 value—signified by the premium—of the option increases and decreases. Investors can unwind their option position early if the current option premium is higher than the premium they initially paid. The investor would receive the net difference between the two premiums.

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

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Closing the European option early depends on the prevailing market conditions, the value of the premium—its intrinsic value—and the option’s time value. The amount of time remaining before a contract’s expiration is the time value. The intrinsic value is an assumed price based on if the contract is in-, out-, or at-the-money. It is the difference between the stated strike price and the market price of the underlying asset. If an option is close to its expiration, it’s unlikely an investor will get much return for selling the option early, because there’s little time left for the option to make money. In this case, the option’s worth rests on its intrinsic value.

Comparing European Options to American Options

Although European options can only be exercised on the expiration date, American options can be exercised at any time between the purchase and expiration dates. American options allow investors to realize a profit as soon as the stock price moves in their favor and enough to more than offset the premium paid.

Investors will use American options with dividend-paying stocks. In this way, they can exercise the option before an ex-dividend date. The ex-date is the day by which investors need to own shares of a company’s stock to receive the dividend payment. A dividend is a payment in either cash or stock to shareholders of record by the ex-date. The flexibility of American options allows investors to own a company’s shares in time to get paid a dividend.

Premium Differences

The flexibility of using an American option comes at a price—a premium to the premium. The increased cost of the option means investors need the underlying asset to move 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 better off buying a lower-priced, European version option and paying the lower premium.

Lower premium cost

Allows trading index options

Can be resold before the expiration date

Settlement prices are delayed

Cannot be settled for underlying asset early

Real World Example of a European Option

An investor purchases a July call option on Citigroup Inc. (C) with a $50 strike price. The premium is $5 per contract—100 shares—for a total cost of $500 ($5 x 100 = $500). At expiration, Citi is trading at $75. In this case, the owner of the call option has the right to purchase the stock at $50—exercise their option—making $25 per share profit. When factoring in the initial premium of $5, the net 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 time of the call option’s expiration. Since the stock is trading below the strike of $50, the option isn’t exercised and expires worthlessly. The investor loses the premium of $500 paid at the onset.

The investor can wait until expiry to determine whether the trade is profitable, or they can try to sell the call option back to the market. Whether the premium received for selling the call option is enough to cover the initial $5 paid is dependent on many conditions including economic conditions, the company’s earnings, the time left until expiration, and the volatility of the stock’s price at the time of the sale. There’s no guarantee the premium received from selling the call option before expiry will be enough to offset the $5 premium paid initially.

American vs. European Options: What’s the Difference?

American vs. European Options: An Overview

American and European options have similar characteristics but the differences are important. For instance, owners of American-style options may exercise at any time before the option expires. On the other hand, major broad-based indices, including the S&P 500, have very actively traded European-style options, while owners of European-style options may exercise only at expiration.

Key Takeaways

  • All optionable stocks and exchange-traded funds have American-style options while only a few broad-based indices have American-style options.
  • European index options stop trading one day earlier, at the close of business on the Thursday preceding the third Friday of the expiration month.
  • The settlement price is the official closing price for the expiration period, establishing which options are in the money and subject to auto-exercise.

American Options

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

The settlement price is the official closing price for the expiration period, establishing which options are in the money and subject to auto-exercise. Any option that’s in the money by one cent or more on the expiration date is automatically exercised unless the option owner specifically requests his/her broker not to 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 do not count when determining the settlement price.

Explaining American and European Options

With American-style options, there are seldom surprises. If the stock is trading at $40.12 a few minutes before the closing bell on expiration Friday, you can anticipate that 40 puts will expire worthlessly and that 40 calls will be in the money. If you have a short position in the 40 call and don’t want to be hit with an exercise notice, you can repurchase those calls. The settlement price may change and 40 calls may move out of the money, but it’s unlikely the value will change significantly in the last few minutes.

European Options

European index options stop trading one day earlier, at the close of business on the Thursday preceding the third Friday of the expiration month.

It is not as easy to identify the settlement price for European-style options. In fact, the settlement price is 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 each stock in the index is determined. Individual stocks open at different times, with some of these opening prices available at 9:30 a.m. ET while others are determined a few minutes later.
  • The underlying index price is calculated as if all stocks were trading at their respective opening prices at the same time. This is not a real-world price because you cannot look at the published index and assume the settlement price is close in value.

European-style options pose special risks for options traders, requiring careful planning to avoid systemic exposure.

Exercise Rights

When you own an option, you control the right to exercise. Occasionally, it may be beneficial to exercise an option before it expires, to collect a dividend, for example, but it’s seldom important. When you sell an American-style option, you sell the option without owning it and are assigned an exercise notice before expiration and are short the stock.

The only time an early assignment carries significant risk occurs with American-style cash-settled index options, suggesting the easiest way to avoid early-exercise risk is to avoid American options. If you receive an assignment notice, you must repurchase that option at the previous night’s intrinsic value, placing you at serious risk if the market undergoes a significant move.

Cash Settlement

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

  • No shares exchange hands.
  • You don’t have to worry about rebuilding a complex stock portfolio because you don’t lose active positions if assigned an exercise notice on calls you wrote, as in covered call writing or a collar strategy.
  • The option owner receives the cash value and the option seller pays the cash value of the option. That cash value is equal to the option’s intrinsic value. If the option is out of the money, it expires worthless and has zero cash value.

These cash-settled options are almost always European-style and assignment only occurs at expiration, thus the option’s cash value is determined by the settlement price.

Settlement Price

The settlement price is often a surprise with European-style options because, when the market opens for trading on the morning of the third Friday, a significant price change may occur from the previous night’s close. This doesn’t happen all the time but it happens often enough to turn the apparently low-risk strategy of holding the position overnight into a gamble.

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

  • If the option is almost worthless, holding on and hoping for a miracle is not a bad idea. Owners of low-priced options, worth a few nickels or less, have earned hundreds or thousands of dollars when the market shifted higher or lower on Friday morning. However, these options expire worthless most of the time.
  • If you own an option that has a significant value, you have a decision to make. The settlement price could make the option worthless or double its value. Do you want to roll the dice? It’s a risk-based decision that individual investors need to make for themselves.

When short the option, you face a different challenge:

European-Style Option

A European-Style option is an option which can only be exercised on expiration date. This is different from American-Style options which can be exercised any time prior to expiry. Hence, European-Style options are sometimes less valuable than American-Style options. Currently, a number of index options traded on the marketplaces are European-Style.

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