Two of the most popular types of options are American and European. American and European options have a lot in common, but there are some key differences that are important for investors to understand.
Options Basics
One of the reasons investors like options trading is that it provides the right, but not the obligation to the buyer, to buy (call) or sell (put) an asset. Making the choice to buy (call) or sell (put) is known as exercising the option.
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Like all derivatives, the value of options reflects the value of an underlying asset. The value of an option changes as its expiration approaches and according to the price of the underlying asset. Investors using a naked option trading strategy may not have the cash or assets set aside in their portfolio to meet the obligations of the contract.
If the value of the contract or the underlying asset doesn’t increase, the investor would choose to let it expire and they lose only the premium they paid to enter into the contract. Both put and call options contracts include a predetermined price to which the buyer and seller agree, and the contract is valid for a specified period of time.
After the contract ends on the expiration date, so does the option holder’s ability to buy or sell. There are many different options trading strategies that investors can use.
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What Are American Options?
America options are the most popular, with both retail investors and institutional investors using them. One of the reasons for their popularity is their flexibility. Traders can exercise their right to buy or sell the asset on any trading day during the term of the agreement.
Most often, American stock options contracts have an expiration period between three and twelve months.
American Option Example
Say an investor purchases an American call in March with a one-year expiry date. The contract states that the investor has the option to purchase stock in Company X for $25 per share. In options terminology, $25 would be known as the option’s strike price. As the price of the underlying stock asset changes, the value of the option also changes.
After the investor purchases the American call options, the value of the stock increases. Within a few months the price was $50. The investor decides to exercise their option to buy, purchasing 100 shares of the stock at the agreed upon strike price of $25/share, paying a total of $2,500. The investor then sells the shares at the current market price of $50/share, making a profit of $2,500 because their value had doubled, not including the premium paid.
Investors can also buy put options, which give them the right to sell instead of the right to buy. With put options the scenario is reversed in that the investor would exercise their right to sell if the asset decreased in value.
What Are European Options?
European options are similar to American options, but holders can only exercise them on the expiration date (not before), making them less flexible.
European Options Example
Let’s say an investor purchases a European call option for 100 shares of Company X with a strike price of $25 and an expiration date six months from the time of purchase. Three months after the contract starts, the price of the stock increases to $50/share. The investor can’t exercise the right to buy because the contract hasn’t reached the expiration date.
When the option holder is able to exercise three months later, the stock is down to $30/share. So the investor can still exercise the option and make a profit by purchasing 100 shares at $25 and selling them for $30. The investor would also need to subtract the upfront premium they made, so this scenario wouldn’t be nearly as profitable as the American option scenario.
This is why European options are not as valuable or popular as American options. Options pricing reflects this difference. The premium, or price to enter into a European option contract is lower. However, traders can sell their European options at any point during the contract period, so in the example above the trader could have sold the option for a profit when the stock price went up to $50/share.
American Style Options vs European Style
American and European options are similar in that they have a set strike price and expiration date. But there are several key differences between American and European options. These include:
Trading
One main difference between American and European options is traders typically buy and sell European options over-the-counter (OTC) and American options on exchanges.
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Premiums
American options typically have higher premiums than European options since they offer more flexibility. If the investor doesn’t exercise their right to buy or sell before the contract expires, they lose the premium.
Settlement
European options tend to relate to indices, so they settle in cash. American options, on the other hand, typically relate to individual stocks or exchange-traded funds and can settle in stock or cash.
Settlement Prices
With American options, the settlement price is the last closing trade price, while with European options the settlement price is the opening price of index components.
Volume
American options typically have a much higher trading volume than European options.
Exercising Options
Traders can only exercise European options at the expiration date, while they can exercise American options at any point during the contract period. Traders can sell either type of option before its expiration date.
Pricing Models
A popular pricing model for options is called the Black-Scholes Model. The model is less accurate for American options because it can’t consider all possible trading dates prior to the expiration date.
Recommended: Black-Scholes Model Explained
Underlying Assets
The underlying assets of most American options are related to equities, European options are typically pegged to indices.
Risks of Americans and European Options
American options are riskier to an options seller because the holder can choose to exercise them at any time.
For buyers, it’s easier to create a hedging strategy with European options since the holder knows when they can exercise their right to buy or sell. Day traders and others who invest in options realize that there are risks involved with all investing strategies, along with potential reward.
The Takeaway
Options are one commonly traded type of investment, and many traders use them to execute a trading strategy. However, it’s possible to build a portfolio without trading options as well.
If you’re interested in options trading, one great way to get started is by checking out SoFi’s options trading platform. With an intuitive design, this platform is made to be user-friendly. Investors can trade options from the mobile app or web platform, and they can find more information about options through the educational resources offered.
Photo credit: iStock/AleksandarNakic
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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