A European Option Explained
DEFINITION:
A European option is a type of options contract where investors can only use the option on its specific expiration date.
A European option is a certain type of contract where investors can only act on the option at its expiration date. They have the choice to use the option or let it expire without doing anything. If it's a call option, they can buy shares at a set price. For a put option, they can sell shares at a specific price.
For instance, if someone buys a European put option for a company's stock with an expiration date in June and a price at ₹50, they can only use that option on the expiration date in June. If the stock's price drops below ₹50, they could buy shares at the market price and then sell them using the option for ₹50, making a profit. But they can't do this until the expiration date in June.
To make money from a European option before it expires, the holder has to sell the option to another person for a higher premium than what they initially paid.
If the price of XYZ goes above ₹50 before the option's expiration, the investor probably won't use it because that would lead to a loss. Even if the option could have been profitable at some point before it expires, the holder can't use it.
European options are simpler compared to other types. Sellers don't stress about the option being used early. Buyers don't need to figure out the best time to use the contract. They just wait until the expiration date to make a decision.
American options serve as the main alternative to European options. The key difference lies in when the option holder can use the contract.
| European Option | American Option |
| Exercisable only on the expiration date | Exercisable any time before the expiration date |
| Less flexibility means they are generally worth less and have a lower premium compared to American options | More flexibility means they are generally worth more and command a higher premium compared to European options |
| Typically some index options available in the U.S. are European options | Typically most U.S. stock options are American options |
| Typically traded in the over-the-counter (OTC) market | Typically traded on exchanges |
With a European option, the option holder can only use it on the expiration date. However, an American option allows the holder to exercise it anytime between when it's bought and when it expires.
American options offer greater flexibility compared to European options. The option holder can decide to exercise it whenever it becomes profitable. This eliminates concerns about the underlying security's price changes that might affect profitability by the expiration date.
Typically, American options have higher premiums because of their flexibility. Holders pay more for the option's ability to be exercised whenever they choose.
Sellers of options face less certainty because the option could be exercised at any moment. To compensate for this risk, they can ask for higher prices when selling options.
Pros
Cons
When trading options, it's crucial to consider the type of option involved. European options are more predictable, making them favorable for sellers. On the other hand, American options provide flexibility for early exercise, benefiting buyers.
Exercising an American call option early on a stock without dividends is rarely advised. This means the flexibility paid for with a higher premium might not be utilized. In such cases, choosing a European option could be a better option.
Yet, purchasers should consider the limitations on exercising the contract as it could impact the profit potential of the option.
