The Difference Between American and European Options
There are two styles of options trading that traders can benefit from – American vs European options. Don’t let these names confuse you. While the names suggest geographical markets for trading options in the United States and abroad, that isn’t the case.
American and European options are tied to different underlying securities, although both types of options are traded on the New York Stock Exchange (NYSE). American and European options are very similar, but the two styles of options have significant distinctions that options traders should understand. While both types maintain a degree of risk, the differences in those risks should be acknowledged and considered before laying out a trading strategy.
So let’s take a deep dive into what American and European options are, the contrast between the two, and the differences in how they are traded.
American vs European Options
The main difference between American and European Options is that a trader can only exercise a European style option at its expiration date. For instance, regardless of how well a position does in the market. The trader can’t capitalize on their position until the expiration date.
American options operate differently as they can be exercised at any point between the start of the contract and the close of the expiration date. They present a lot more wiggle room but the premium to buy an American option is generally more expensive.
What is an example of American vs. European options that we trade regularly? SPY and SPX. SPY is American and SPX is European.
Why are SPY and SPX different? You can exercise a SPY option to get shares of SPY, but you cannot exercise an SPX option to get shares of SPX.
What does that mean for traders? Sellers of American options like those on SPY have to worry about being assigned early on in-the-money options, while sellers of SPX options do not. Buyers of options need to close out-of-the-money American positions before expiration if they don’t want to exercise them, whereas European options mostly settle in cash and can be held to expiration.
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What are American Options?
American options are based on the direct correlation of value tied to a financial security, such as stocks, bonds, or ETFs. When traders delve into the options market, American options are your standard options contract. American options contracts give the buyer of these contracts the right to purchase or sell the underlying stock; however, the buyer is not obligated to do so under any circumstance. This is an important feature to remember.
Options traders must meet the basic requirements before placing an American options trade. Trading platforms such as tastytrade, TradeStation, thinkorswim©, and other platforms will often require additional information from traders to allow them to trade options. Before trading options, traders should understand the trading platform they trade with as they can be wildly different. The requirements to trade options may seem too much to endure, but it’s for the trader’s protection, as options are a risky method of trading.
As you get started trading options, whether on U.S. Stock Exchanges, or foreign stock exchanges, keep the following in mind:
- Only trade with capital you’re willing to lose; trading options are risky.
- When opening an options account, brokerages typically require you to open a margin account to trade vertical spreads.
- Determine a trading plan before getting started; traders can get distracted by chasing every setup without a clear plan of action. Focus on one or two essential setups that you feel comfortable trading.
- Personal financial information records must be complete as platforms want to know your net worth, income, employment status, and risk tolerance.
- Your options strategy should be documented as trading platforms will inquire how you intend to trade options.
Traders can buy and sell options once the account is established on the desired trading platform. The well-known brokerages, like TD Ameritrade, also provide plenty of information within the platform that you can utilize in your trading and investing research.
Once you have your brokerage account, these are the types of options that can be traded:
Call options – If you think a stock is going up, buy a call option. A call option allows you to buy a stock at the strike price even if the stock is above that price. The options contract allows the holder to buy the stock on or before a specified date, but they are not required to buy it. The holder, or buyer, of the call option can sell the call option and keep the profits, sell it for a loss if the stock and call value go down, or do nothing and let it expire.
Put options – Put options are almost identical to call options; the only difference is that the put options holder has the right to sell (not purchase) the security on or before a specified date. If you think a stock is going down, buy a put. It secures your ability to sell the stock to someone else at the strike price even if the stock price is below that.
What are European options?
Like American options, European options allow the holder of the option the right to buy or sell an options contract, but not the obligation. European stocks are associated with the indexes of the market. European options have many similarities to American options, but there is a major difference.
Unlike American options that allow a trader to sell before the expiration date, European options do not allow traders to exercise before the expiration date. This doesn’t mean you can’t get out of the options trade; this just means you can’t convert the option to shares of stock until the expiration date.
Traders who possess a European options contract have to decide to buy or sell on the expiration date. There are no exceptions to that rule.
What makes options so appealing to U.S. traders is the flexibility of exercising them between the purchase and the expiration date. With European options, traders can’t take advantage of that flexibility. It’s an important point to remember, before purchasing a European option, that European options holders have to wait to decide to buy or sell the stock at the expiration date. Quite simply, they have one day to exercise their position.
European Options Example
Suppose a trader bought a European call options contract with a strike price of $100, with a 30-day expiration. The premium to buy the contract is $10. Since one options contract represents 100 shares of stock, this $10 option will equal a $1,000 premium that the trader must pay to the seller. The expiration date is 30 days from the purchase date of the European options.
The index or stock the option is connected to can increase to $50 over the strike price before the expiration date, which might compel the trader to exercise the option contract and buy the stock much lower than it is priced now. Since it’s a European option, the trader must wait until the expiration date to exercise the option.
The trader, at this time, can only hope that the stock will remain at $50 or move above the strike price at the time when the trader is allowed to exercise their position.
So, looking at it the other way, suppose the stock lost $50 over the strike price. The trader can let the call option expire and walk away, taking the $1,000 loss.
One Big Difference Between Options
The primary difference between American and European options is the time that traders can exercise their right to buy or sell their options position, there are other differences worth noting.
American options offer traders a lot more flexibility. Traders who purchase American options pay a higher premium to have the ability to convert their option to underlying shares at any time between the purchase and expiration dates.
Generally, the American options have much higher premiums than European options. Since European options don’t offer traders the ability to buy and sell the underlying shares before expiration, their premiums are generally cheaper.
While it isn’t as risk-averse, buying European options with cheaper premiums can be an effective way to trade with the right trading strategy.
American and European Options Strategies
There are many strategies that traders can utilize when trading options. Traders can day trade, swing trade, and use other popular options strategies with American options.
Traders typically apply options strategies before important dates like FOMC announcements and earnings reports. These same traders who focus on European options can strategically buy them on specific days that allow the expiration date to fall on a date relevant to the trader and their position.
Traders need to remember that while European options generally have cheaper premiums, it has their associated risks. Traders who take advantage of the cheaper premiums must understand the limitations and risks as they consider trading with European options. If options trading appeals to you then consider joining us in the Simpler Free Trading Room. Traders who sign up, get instant access to the free trading room, recorded sessions, and free classes. Register today and trade alongside a professional for FREE!
FAQs on American and European Options
A: Traders can only exercise a European style option at its expiration date while American options can be exercised at any point before the expiration date.
A: SPY and SPX. SPY is American and SPX is European. You can exercise an SPY option to get shares of SPY, but you cannot exercise an SPX option to get shares of SPX.
A: European options tend to be less expensive than American options because a European option trader typically assumes less risk. Conversely, American options are generally more expensive due to the American options trader taking on more risk.
A: Options can be good for beginners because you have no obligation to do anything if you’re not happy with the direction your contract is moving. Additionally, options allow for a more conservative approach and smaller capital requirements.
A: Before you buy options, make sure you understand how they work, have a brokerage account, and make a trading plan. You can also consider paper trading as a practice.
Original Date Published: 6/20/2018