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American vs. European Options: What’s The Difference?

Sebencapital

Published
19/12/23
American vs. European Options: What’s The Difference?

American and European options refer to how options can be exercised. American options allow exercising at any time before the expiration date, while European options only permit exercise at expiration. Economist Paul Samuelson introduced these terms to distinguish between these two styles of options and are not related to where they are traded.

Both styles cater to different underlying assets and trading tactics, each carrying distinct tax implications.

What’s the Difference Between American and European Options?

The two options styles serve various underlying assets and trading methods. Additionally, they possess varying tax implications.

AMERICAN STYLEEUROPEAN STYLE
UNDERLYING ASSETStocks and ETFsMost indexes
EXERCISEAnytime before expirationAt expiration
SETTLEMENTSharesCash
TAX TREATMENTVariesVaries

Underlying Asset

Options are deals that grant the purchaser the choice, but not the duty, to purchase or sell a financial asset, like a stock, at a specific price and time known as the "expiration." When someone holds the right to sell, it's termed a "put," and if they have the right to buy, it's called a "call."

These deals are called "derivatives" because their worth is connected to another financial asset, like a stock, an exchange-traded fund (ETF), or a commodity, such as gold.

Note

Usually, options linked to stocks and ETFs are American-style options and are more widespread. However, not all, but many index options are European-style options.

Exercise

Those owning American-style options can buy or sell a stock or ETF at any time before the contract ends. On the other hand, European contracts can only be exercised on the expiration date.

Settlement

When American options are exercised, the stock or ETF is physically transferred from the seller to the buyer. However, only cash is exchanged when European options are exercised because their value relies on fluctuations in a financial index, not the price of a specific stock, ETF, or commodity.

Tax Treatment

Taxation for American and European options can differ based on how long you hold them and the complexity of your trades. Typically, the holding period of the options decides whether they qualify for short-term or long-term capital gains treatment.

Certain European index options might receive preferential tax treatment, even if held for less than a year. As per Section 1256 of the U.S. tax code, specific index options could be taxed at a rate of 60% for long-term capital gains and 40% for short-term capital gains.

American-Style Options vs. European-Style Example

In most cases, investors don't have the option to choose the style of their options. Stocks and ETFs usually follow the American style, while indexes, with a few exceptions, tend to be European style. However, there's a strategy where investors can pick the style that suits them best.

For those interested in trading options based on the S&P 500, they have two options: They can either trade options on Exchange Traded Funds (ETFs) that hold all the individual securities in the index, like the SPDR S&P 500 ETF (known as SPY), or they can opt for the S&P 500 Index Options (known as SPX) on the Chicago Board Options Exchange (CBOE).

SPDR OPTIONSS&P 500 INDEX OPTIONS
UNDERLYING ASSETETFS&P 500 Index
STYLEAmericanEuropean
DIVIDEND POTENTIALYesNo

The SPX offers different products. Some of these products permit trading throughout global hours (however, S&P 500 Index Options do not). Additionally, there are products available in smaller sizes, known as minis, which are 1/10th the size of the regular ones.

The Standard & Poor's 100 Index Options (OEX) provides options that come in two styles: American-style and European-style.

The Bottom Line


American-style and European-style options differ in their exercise periods, the assets they cover, and their tax implications. The type of option is usually set in advance. While options can bring high rewards, they also carry considerable risk.

It's crucial to grasp their functioning and the potential outcomes before investing. Conduct thorough research, understand the basics, and develop informed predictions about the expected movements of the underlying assets before getting involved in options trading.

Note

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Written by Sauravsingh

Techpreneur and adept trader, Sauravsingh Tomar seamlessly blends the worlds of technology and finance. With rich experience in Forex and Stock markets, he's not only a trading maven but also a pioneer in innovative digital solutions. Beyond charts and code, Sauravsingh is a passionate mentor, guiding many towards financial and technological success. In his downtime, he's often found exploring new places or immersed in a compelling read.

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