In the options world there exists two different exercise styles. These are called American options and European Options. The main difference between the two is that American options can be exercised before the expiration date, while European options can only be exercised at the expiration date. This of course has important implications for the options trader, which we will briefly discuss below.
What is important to remember is that the terms ‘American’ and ‘European’ have nothing at all to do with where the options are traded. In fact both types of options are trades in both
America and Europe.
One of the most important implications with a European style option is that it will normally be cheaper than its American-style counterpart. This is because it is less flexible.
While a European-style option can only be exercised on the expiration date, it can still be bought and sold before the time, just like American-style options. In this regard it is therefore similar to a warrant or even a futures contract.
Where European-style options really differ from American-style options is in the fact that they cannot be assigned before expiration. The dreaded fear of early assignment (which is often highly overrated) with which all writers of American style options have to live does therefore not exist with European-style options.
Another difference between the two exercise styles is that European-style options normally stop trading the day before expiration. This means a trader will not be able to get out of a losing trade on the last day, neither will he or she be able to exit in a profitable position before it retracts below the strike price.
Pricing of American-style versus European-style options
As mentioned above, European-style options are normally cheaper than American-style options. This explains why the popular theoretical options model called Black-Scholes very often calculates an option price that is lower than the actual price: it was developed for European-style options, so it doesn’t work so well with American-style options.
On expiration day the settlement price of European-style options are also calculated in a different way than that of American-style options. With the latter the closing price of the underlying asset is used to determine whether an option ended ITM, ATM or OTM.
European-style options go through a mark-to-market process where the final settlement price is only determined a few hours after expiration. This understandably creates a lot of stress for traders who are in possession of options for which the final price closed just a few cents on either side of their strike price. They literally have to await the verdict of the judges
before they know whether they made a profit or a loss.
How to know
How does one know whether the options one is buying or selling are European-style or American-style? An easy hint is that virtually all cash-settled options are European-style. Index options are usually European-style too, while nearly all stock options traded in the
United States are American-style options.