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What Is a European Option?

Sebencapital

Published
19/12/23
What Is a European Option?

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.

Definition and Examples of a European Option

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.

Note

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.

European Option vs. American Option

American options serve as the main alternative to European options. The key difference lies in when the option holder can use the contract.

European OptionAmerican 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 optionsMore 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 optionsTypically most U.S. stock options are American options
Typically traded in the over-the-counter (OTC) marketTypically 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.

Note

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 and Cons of a European Option

Pros

  • More predictable for options sellers
  • Options are less expensive to purchase

Cons

  • Generally sold over the counter
  • Options buyers have less flexibility
Pros Explained
  • European options provide more predictability for options sellers. Since these options can only be exercised upon expiration, sellers don't need to worry about early exercise.
  • European options usually cost less compared to American options. This means buyers can get more contracts with the same amount of money when purchasing European options.
Cons Explained
  • Usually not traded on exchanges, European options are commonly sold over the counter. They tend to be less easily bought and sold, leading to lower liquidity compared to American options.
  • European options offer limited flexibility. to the buyer regarding when they can exercise the option. This limitation might cause the buyer to miss out on profit opportunities that an American option could have provided due to its more flexible exercise schedule.

What It Means for Individual Investors

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.

Note

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.

Key Takeaways

  • European options can only be used or activated on the date they expire.
  • European options generally have lower value compared to more adaptable options contracts.
  • Before the expiration date, options buyers can solely profit by selling the contract to another person.

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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