European options trading
When you exercise a put option , you sell shares at the strike price. This is pretty simple stuff and although option rookies may have questions, most investors understand the process. Some of the most actively traded options are European style. Investors must be aware of the differences between European and American options. This is one of those details that you ignore at your peril. European options cannot be exercised prior to expiration da y, whereas American style options can be exercised any time before the option expires.
This property of European options benefits option sellers. The investor who sold calls becomes short stock instead of options. If you owned a spread position, one part of the spread has been covered. This is a very bad situation. European options settle in cash. No stock changes hands. When you exercise European style options, you receive the cash value of that option. Cash settlement works like a charm. You own 4 SPX Oct calls. 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. 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. 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.