The world of options is divided into two categories or styles. So what are the two styles? Well the two are American style and European style options. Both types tend to have a lot in common, however, there are some distinct differences as well. This post will help explain what they even are, their similarities, and more importantly, their differences.
American Style Versus European Style Options
A similarity of the two is that both types of options have a set strike price, as well as a set expiration date. In addition, both option styles are traded on exchanges, and both use somewhat similar structures on their ticker symbols.
Most traders are at least somewhat familiar with the American options. For instance, options that are traded on major corporations such as Tesla, Lulu, and Google are American options.
European options may be less familiar. However, those who trade options on stock indexes like the Nasdaq or the S&P 500 are more than likely trading some European style options – whether they know it or not.
It’s important to note their substantial differences though because if a trader isn’t aware of these differences, it can cause a hefty mess.
Difference in Option Exercise
The first big difference is that a trader can only exercise a European style option at its expiration date. Meaning when the option is fully ‘matured.’ Because of this, European option traders tend to have less risky positions.
Whereas, American options can be exercised at any point prior to the close of the expiration date. They present a lot more wiggle room, but are generally more expensive as a result.
American and European Index Options
On top of only being able to exercise certain options at certain times, there’s stipulations around index options for each style. American index options stop trading at the close on the third Friday of the expiration month. There are some exceptions to this rule, for instance, quarterlies because they don’t stop until the last trading day of the quarter. Hence the name, quarterlies.
European index options beat Americans to the punch though. They stop trading the day prior to the third Friday. So, the Thursday before expiration.
Possibly the most confusing difference between the two is their differing settlement prices, meaning the official closing price for the expiration period. For American options, it’s just the confirmed closing price. This means the last trade before the close on expiration day (the third Friday). Keep in mind, any trades post close aren’t factored into the settlement price.
For European options, however, the settlement price can be a little tricky.
The idea is that on that ominous third Friday of the month, the opening price (so the first trade of the day) is determined. Keep in mind though, that certain stocks start trading at different times. So when the settlement price for European options is calculated, it incorporates the idea that all the stocks are trading at their respective opening prices at the same time.
As a result, the settlement price for European options isn’t made available until several hours after the close of expiration.
Risk Against Expense in American and European Options
In addition, European options tend to be less expensive than American options as mentioned earlier. Part of the reason for this is because a European option trader typically assumes less risk, as there’s little worry because the option can’t be exercised until expiration.
On the other hand, American options are generally more expensive due to the American option trader taking on more risk. Generally it’s harder to plan for and hedge risks because it’s unknown when the option will be exercised.
Due to these major differences, as an options trader it’s important to be aware of the different risk factors that stem from the ability to exercise or not exercise an option at various times. This alone can play a large part in a trader’s overall profit potential on that option trade.