American vs. European Options: An Overview
American and European options have similar characteristics, but there are important differences: the holder of an American option can exercise it at any time before the option expires. A European option can only be exercised upon expiration.
While most equity options are American-style options, many broad equity indexes, including the S&P 500, have actively traded European-style options.
Key Takeaways
Most stocks and exchange-traded funds have American-style options. Equity indexes, including the S&P 500, have European-style options. European index options expire one day early, at the close of business on the Thursday prior to the third Friday of the expiration month. The settlement price is the official closing price for the expiration period. This determines which options are in the money and subject to automatic exercise.
American Options
An option is a contract to derive value from an underlying asset or investment. The owner of the option has the right to buy or sell the underlying asset (such as a stock) at a fixed price (the strike price) by a specific expiration date in the future. A call option gives the owner the right to buy a stock. A put option gives the owner the right to sell a stock. An upfront fee, called a premium, is what an investor pays to buy the option.
Stock options typically cover a single stock. Index options are based on a basket of stocks that can represent the entire stock market or a portion of a market, such as a particular industry. American-style stock options can be exercised before expiration. European-style index options can only be exercised at expiration.
Investors can exit an options position, including European-style options, prior to expiration by selling it, potentially resulting in a profit or loss between the premium paid and the premium received.
All optionable stocks and exchange-traded funds (ETFs) have American-style options. Only a few broad indexes have American-style options. American index options, with a few exceptions, expire at the close of business on the third Friday of the expiration month. Some options are issued quarterly and trade until the last trading day of the calendar quarter. Weekly options expire on the Wednesday or Friday of a given week.
The settlement price is the official closing price for the expiration period. This determines which options are in-the-money and subject to automatic exercise. Options that are in-the-money by one cent or more on the expiration date will be automatically exercised unless the option holder explicitly requests that the broker not exercise the option.
The settlement price of the underlying for American-style options is the regular closing price or the last trade before the market closes on the third Friday of the month. After-hours trading is not taken into account in determining the settlement price.
With American-style options, surprises are rare. If the stock trades at $40.12 a few minutes before the close of trading on Friday expiration, you can expect the 40 put to be worthless and the 40 call to be in the money. If you have a short position on the 40 calls and don’t want to receive an exercise notice, you can buy them back. It’s possible that the settlement price will change and the 40 call will be out of the money, but it’s unlikely that the value will change dramatically in the last few minutes.
European Options
European index options cease trading one day early at the close of business on the Thursday prior to the third Friday of the expiration month.
Determining the settlement price for European style options is not as easy. The settlement price is not released until a few hours after the market opens. The European settlement price is calculated as follows:
The opening price for each stock in the index is determined on the third Friday of each month. Each stock’s opening price varies. Some opening prices are announced as early as 9:30am ET. Others are determined a few minutes later. The underlying index price is calculated as if all stocks were trading at their respective opening prices at the same time. This is not a real-world price, as you cannot look at a published index and assume the settlement prices will be close.
European-style options pose special risks for options traders and careful planning is required to avoid systematic risk.
Enforcement of rights
If you own the option, you control the right to exercise it. Sometimes it can be advantageous to exercise your options before the expiration date and receive the dividend, but this is rarely significant. Dividends are cash paid by companies to shareholders as compensation to investors. If you sell American-style options and receive an exercise notice before the expiration date to short the stock, you sell the option without owning it.
Early allocation only entails significant risk for American-style cash-settled index options, suggesting that the easiest way to avoid early exercise risk is to avoid American options. If you receive an allocation notice, you will be required to buy back the option at its intrinsic value the night before, exposing you to significant risk if the market moves significantly.
Cash settlement
Settling options in cash is advantageous for all parties for several reasons.
No shares are bought or sold. When an exercise notice is issued for a call option issued in a covered call or collar strategy, you do not lose your active position and do not need to worry about restructuring a complicated stock portfolio. The option holder receives the cash value and the option seller pays the option’s cash value, which is equal to the option’s intrinsic value. Options are worthless when they expire and have zero cash value if out-of-the-money.
These cash-settled options are most often European style. Allocation occurs only at maturity. The cash value of the option is determined by the settlement price.
Settlement price
European-style options often have unexpected settlement prices because when the market opens on the morning of the third Friday, there can be a significant price movement from the previous night’s close. This doesn’t happen all the time, but it happens often enough to turn the low-risk strategy of holding a position overnight into a gamble.
Here’s the scenario facing European options traders on Thursday afternoon, the day before expiration:
If an option has little to no value, there’s nothing wrong with holding on to it in hopes of a miracle. Owners of low-cost options worth a few cents or less have made hundreds or thousands of dollars when the market rises or falls on Friday morning. But these options almost always expire worthless. If you own options with significant value, you have a decision to make. The settlement price could make your option worthless or it could double in value. Do you roll the dice? This is a risk-based decision that each individual investor makes for themselves.
When you short options, you face a different challenge.
If you’re shorting an out-of-the-money option, covering it is a smart move. You can see the stock price approaching the strike price and pay 5 or 2 cents to cover with an American-style option. But with European options there are no warnings. Any out-of-the-money option can be 10 or 20 points in the money, costing you $1,000 to $2,000 per contract if you have to pay the settlement price. Ask yourself whether it’s worth the risk.
What are Derivatives?
A derivative is a financial instrument that is specifically linked to other financial instruments or products, allowing investors to trade risks between them in the market, and is usually settled in cash.
Are options derivatives?
Yes, options are derivatives that give the purchaser or holder the right to buy or sell at a fixed price by a pre-determined date. However, the investor has no obligation to do so.
What are index funds?
An index fund is an ETF or mutual fund that tries to track and match the returns of a particular market index. These indexes monitor a set of securities, such as stocks. While you can’t invest in an index, you can take on the risks and rewards of investing in a fund.
Conclusion
American-style options typically include stocks and ETFs, while many market indexes have European options. Trade expiry and settlement prices are one of the major differences between these options. Make sure you understand these before diving into either type of option. If in doubt, seek professional help.
