Editor's Note: Options are not suitable for all investors. 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. Please see the Characteristics and Risks of Standardized Options.
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Two of the most popular types of options are American and European options. American and European options have much in common, but there are some key differences that are important for investors to understand. Most notably, American options may be exercised at any time up to and upon their expiration date, while European options may only be exercised on their expiration date.
Key Points
• American options offer the right to buy or sell the underlying asset on any trading day on or before the expiration date.
• European options can only be exercised on the expiration date, limiting flexibility.
• American options are often traded on exchanges, while European options are typically traded over-the-counter.
• The pricing of American options usually includes higher premiums due to their increased flexibility.
• European options are generally less expensive and settle in cash, often related to indices rather than specific stocks.
Options Basics
One of the reasons investors might use options trading is that it provides purchasers the right, but not the obligation, to buy or sell an underlying asset. Making the choice to buy (call) or sell (put) is known as exercising an option.
Like all derivatives, the value of an option is determined, to a large extent, by 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.
If the value of the contract or the underlying asset doesn’t increase, the buyer of the option may choose to let it expire and would lose the premium they paid to enter into the contract. Both put and call options contracts include a predetermined strike 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.
Recommended: Call vs Put Option: The Differences
What Are American Options?
American options are among the most popular, with both retail and institutional investors. 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 12 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 itself also changes, but not the strike price, which is fixed.
After the investor purchases the American call options, the value of the stock increases. Within a few months the price is $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 (not including fees). The investor then sells the shares at the current market price of $50/share, making a gross profit of $2,500, not including the premium paid or fees, because their value had doubled.
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.
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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 potentially realize a gain by purchasing 100 shares at $25 and selling them for $30. The investor would also need to subtract the upfront premium they paid, so this scenario would be less profitable than the American option scenario.
In some cases, the European option’s premium (or options price) may be lower because of this difference. 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 contract 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 how they’re traded, associated premiums, and more.
Trading
One main difference between American and European options is that traders typically buy and sell European options over-the-counter (OTC) and American options on exchanges.
Recommended: What Is the Eurex Exchange?
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, and the contract expires worthless, 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 typically the last closing trade price, while with European options the settlement price is typically the opening price of index components.
Volume
American options may have higher trading volumes than European options.
Exercising Options
Traders can only exercise European options at the expiration date, but 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 was designed for European options and does not directly account for early exercise, which may reduce its precision when applied to certain American options.
Underlying Assets
The underlying assets of most American options are related to equities, while European options are typically pegged to indices.
Risks of American and European Options
American options may be riskier for options sellers 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. For day traders and others who invest in options, there are higher risks involved with options trading strategies, along with potential reward.
The Takeaway
One commonly traded type of investment is options trading, 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 have questions about how options may fit into your investment strategy, it may be a good idea to speak with a financial professional.
While SoFi offers American-style options trading, it does not offer European options at this time.
SoFi’s options trading platform offers qualified investors the flexibility to pursue income generation, manage risk, and use advanced trading strategies. Investors may buy put and call options or sell covered calls and cash-secured puts to speculate on the price movements of stocks, all through a simple, intuitive interface.
With SoFi Invest® online options trading, there are no contract fees and no commissions. Plus, SoFi offers educational support — including in-app coaching resources, real-time pricing, and other tools to help you make informed decisions, based on your tolerance for risk.
Frequently Asked Questions
Which is better: American options or European options?
Neither type is inherently better: The right choice depends on a trader’s strategy and goals. American options offer more flexibility since holders can exercise at any point before expiration, but that flexibility comes at a higher premium. European options tend to be less expensive and may suit traders focused on index-based strategies who don’t need early exercise rights.
How to tell if an option is European or American?
The option contract itself will specify the exercise style. As a general rule, options on individual stocks and ETFs are typically American-style, while options on broad market indices — such as the S&P 500 — are typically European-style. Checking with a broker or the exchange where the option is listed is the most reliable way to confirm.
Are American and European call options the same price?
American and European call options on the same underlying asset are not always the same price. American call options generally carry higher premiums because of the added flexibility to exercise early. However, for call options on non-dividend-paying stocks, the two may be priced very similarly since early exercise rarely makes financial sense in that scenario.
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INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE
Options involve substantial risk of loss and the possibility an investor may lose the entire amount invested. Before starting options trading, investors should be familiar with the Characteristics and Risks of Standardized Options . TTax implications with options should be considered. Consult your tax advisor to understand any impacts to your taxes.
Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
Exchange Traded Funds (ETFs): Before investing in Exchange Traded Funds (ETF), always read the fund's prospectus. It contains important information about the fund’s objectives, risks, and fees. You can get a prospectus from the fund company’s website or by emailing our customer service at [email protected].
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
S&P 500 Index: The S&P 500 Index is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S. It is not an investment product, but a measure of U.S. equity performance. Historical performance of the S&P 500 Index does not guarantee similar results in the future. The historical return of the S&P 500 Index shown does not include the reinvestment of dividends or account for investment fees, expenses, or taxes, which would reduce actual returns.
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