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European Style Options: Summary
European Style Options - Definition
An option contract that may be only be exercised upon expiration.
European Style Options - Introduction
European Style Option, or European Option, is one of two options exercise styles in options trading. The other being the American Style Option. The main difference between European Style Options and American Style Options is the fact that European Style Options can only be exercised during expiration while American Style Options can be exercised at anytime prior to expiration.
This tutorial shall explore in more detail what European style options are, how they are priced, their characteristics and how to tell if an option is European style or American Style.
Two Main Exercise Styles
The two main options exercise styles are American Style exercise and European Style exercise. These names has nothing to do with where the options are traded. In fact, most exchanged traded options all over the world are American Style Options. The only difference between European Style Options and American Style Options is the fact that European style options can only be exercised upon expiration while the American style option can be exercised at anytime prior to expiration. Consequently, due to this difference, the pricing method of European Style options and American Style options are also different. Generally, European style options are cheaper than American style options due to the lack of flexibility in exercising.
European Style Options - Characteristics
European style options are the same as warrants in that they can only be exercised upon maturity. In fact, European style options are AUTOMATICALLY exercised upon expiration if they are in the money at that point in time which makes them behave more like futures contracts. However, they can be sold at any time prior to expiration (or rather by 1 day before expiration) in order to take profit or stop loss, just like an American Style Option.
Most cash settled options that do not deliver an actual asset if exercised tends to be European style options since there are no benefits to exercising a cash settled option early at all. As such, most index options are European style options instead of American style options. Yes, almost all equities options or physically settled options traded all over the world are American Style Options.
Recently, there are also European Style options and American style options trading on the same physically delivered underlying asset such as some forex futures options. This provides options writers the benefit of writing European style options which has no risk of early exercise.
Yes, the risk of assignment is one risk all writers of American style options bear and that risk do not exist when writing European style options.
European style options typically stops trading the day before expiration, which makes it impossible to sell the option right before expiration when the profit might be highest. The settlement price of an European style option is also very different from American style options. American style options simply use the final traded price on expiration day as the settlement price while European style options go through a mark to market process much like in futures trading to determine the final settlement price. This is typically released a few hours after expiration which creates some suspense there as to the final profit/loss status especially for options that ended up at the money or just a few cents out of the money on the day before expiration day.
European Style Options Pricing
European Style Options are generally cheaper than American style options due to not being able to be exercised prior to expiration. By cheaper, we mean it carries a lower extrinsic value. In fact, the Black-Scholes Model which is so widely used in options trading today is an options pricing model for European style options and why most of the time, the theoretical value produced by the model is lower than the traded prices for American style options.
How Do We Tell If An Option Is European Style?
Almost all cash settled options are European Style options. So, if you are buying cash settled options, there is an extremely high chance that it is an European style option. Most index options are cash settled options. If you are buying futures options, there are chances that there may be both European and American style options available, so you need to check with your exchange for details before committing to a trade. You can check if an index option is American Style or European style in the US market by going to OIC's Product Specification Page.