American vs. European Options: A Overview
While the characteristics of American and European options are similar, it is important to note that there are some differences. Owners of American-style options can exercise at any time prior to the option’s expiration . European-style options, however, may only be exercised at expiration.
While most equity options can be traded in American style, there are many broad-based equity indexes that trade European-style, such as the S&P 500.
- Stocks and exchange-traded funds most often have American-style options, while equity indices such as the S&P 500 have European-style options.
- European index options are no longer traded at the close on Thursday before the Friday of the expiration month.
- The settlement price is the closing price of the expiration period. It determines which options are available and can be used to exercise auto-exercise.
Options are contracts that derive value from an investment or underlying asset. An option gives the owner the ability to purchase or sell an underlying asset (such a stock), at a fixed amount (called the striking price) on or before a specified expiration date. An option allows the owner to purchase stock. An option grants the owner the option to sell stock. An investor must pay an up-front fee, known as the premium. This is the amount required to buy the option.
Stock options can be for one stock only, but index options can be for multiple stocks. Index options can also represent the entire equity market or a part of it, such as an industry. If it’s American-style, a stock option can be exercised prior to its expiration date. However, an option on an Index can only be exercised after its expiration (if it is European-style). Investors can still unwind their option positions by selling them before expiry. This includes European-style options. However, there may be a gain of loss in relation to the premiums received and paid.
All optionsable stocks and ETFs offer American-style options. Only a few broad-based indexes offer American-style options. American index options stop trading at the close on Friday of the expiration date, with some exceptions.
The official closing price is the settlement price. It determines which options are in money and can be auto-executed. Unless the option owner requests otherwise, any option that is in the money by more than one cent on the expiration date will be automatically exercised. American-style options will settle for the underlying asset, which can be a stock, ETF or index. This price is either the regular closing price, or the last trade before market closes on Friday. Settlement price is not determined by after-hours trades.
Explaining the differences between American and European options
There are rarely surprises with American-style options. You can expect that 40 put options will expire without notice if the stock trades at $40.12 just before the closing Friday. The 40 calls will remain in the money. You can repurchase the calls if you are in a short position on the 40 call. Although the settlement price might change, 40 calls could move out of money. However, it is unlikely that the value will significantly change in the next few minutes.
European index options are no longer traded at the close on Thursday before the Friday of the expiration month.
For European-style options, it is more difficult to find the settlement price. The settlement price for European-style options is not released until after the market closes. This is how the European settlement price was calculated:
- The opening prices of each stock in the index are determined on the third Friday. Different stocks open at different times. Some of these opening prices are available at 9:30 AM. ET, while others will be determined within a few minutes.
- As if all stocks traded at their respective opening prices simultaneously, the underlying index price was calculated. This is not a true-world price since you can’t look at the published index to assume that the settlement price is the same.
Options traders who trade European-style options face special risks. It is important to plan carefully in order to avoid being exposed.
You have the option to exercise it if you are the owner. Sometimes, exercising an option before it expires can be advantageous, such as to receive a dividend. However, this is rarely a significant benefit. Dividends are cash payments that companies pay to shareholders as a reward for investors. You can sell an American-style option but not own it. An exercise notice is sent before the expiration date and you are short the stock.
Only American-style cash-settled, index options carry significant risk. This is why it’s best to avoid American options. You must repurchase the option you received in an assignment notice at the previous night’s intrinsic value. This puts you at risk of significant market moves.
All parties are benefited when the options can be settled in cash
- No shares exchange hands.
- It’s not necessary to worry about rebuilding complex stock portfolios. Active positions aren’t lost if you receive an exercise notice for calls you wrote (e.g. covered call writing, collar strategy).
- Option sellers pay the cash value. The cash value is paid to the option owner. This cash value equals the intrinsic value of the option. The option expires when it is worthless and has no cash value.
These cash-settled options have a European style and are assigned only at expiration. The settlement price determines the cash value of the option.
With European-style options, the settlement price can be a surprise because a significant price movement could occur at the opening of trading on Friday morning. This is due to the fact that the previous night’s closing may have been delayed. Although it doesn’t always happen, it is enough to make the seemingly low-risk strategy for holding the position overnight a gamble.
Here’s what European option traders face Thursday afternoon, the day before expiration.
- It is a good idea to hold on to the option and hope for a miracle, even if it is nearly worthless. Low-priced options that are worth just a few cents or less have been worth hundreds of thousands or even millions of dollars. These options are usually worthless and expire.
- You have to make a decision if you own an option with a high value. You could lose the option or make it worth twice as much. Are you willing to gamble? Individual investors must make this risk-based decision.
If you reduce the option, you will face a new challenge:
- Covering is a smart move when you are short an out-of-the-money option. American-style options allow you to see when the stock is about to strike and spend as little as a nickel to cover it. European options are more transparent and come with warnings. If you are forced to settle the settlement price, any out-of-the-money option could move 10 to 20 points into the cash. It can cost anywhere from $1,000 to $2,000 per contract. It is just too risky.