American Options Investors: Should You Go Euro?
Just as there are two different types of options (puts and calls), so there are two main styles of options: American and European. These options have many characteristics in common, but it's the differences between them that are important. Many rookies, as well experienced traders, have suffered unnecessary losses because they were unaware of the differences. In this article, we'll discuss these differences and how they affect you, so you can discover how to avoid potentially costly problems. (For background reading, see How do you tell whether an option is American or European style?)
Differences
There are four key differences between American- and European-style options.
Exercise Rights
When you own an option, you control the right to exercise. Occasionally, it may be beneficial to exercise an option before it expires (to collect a dividend, for example), but it's seldom important. (Learn more in Dividends, Interest Rates And Their Effect On Stock Options.)
When you are short an American-style option (you sold the option without owning it) and are assigned an exercise notice prior to expiration, instead of being short the option, you are now short the stock. Unless your account is too small to carry a short stock position, this is not a problem, and if your account is that small, you should probably not be trading options. (Read more in Options Hazards That Can Bruise Your Portfolio.)
The only time an early assignment carries any significant risk occurs with American-style, cash-settled index options. The only such options are OEX, so the easiest way to avoid the early-exercise risk is to avoid trading OEX options. When you receive an assignment notice in the morning, you must repurchase that option at the previous night's intrinsic value. That may place you at serious risk if the market undergoes a significant move, because that forced purchase makes your position different from the one you thought you owned. (To learn more, read Understanding Option Pricing.)
Cash Settlement
It's advantageous to everyone when options are settled in cash:
Settlement Price
With American-style options there are seldom any surprises. When the stock is trading at $40.12 a few minutes before the closing bell on expiration Friday, you can anticipate that the 40 puts will expire worthless and that the 40 calls will be in the money. If you have a short position in the 40 call and don't want to be assigned an exercise notice, you can repurchase those calls. The settlement price may change, and those 40 calls may move out of the money, but it's unlikely that the value of those calls will change significantly in the last few minutes.
With European-style options, the settlement price is often a huge surprise, which may prove beneficial to some, but a disaster for many others. That's because when the market opens for trading on the morning of the third Friday, there is often a gap, a significant price change from the previous night's close. This doesn't happen all the time, but it happens often enough to turn the apparently low-risk idea of holding that position overnight into a large gamble.
When you own the European option, here's the situation you face Thursday afternoon, the day before expiration:
If you decide to trade index options, please be certain you understand the differences between American- and European-style options. More importantly, to avoid a significant loss, it's essential that you understand how the settlement price of European options is determined. It makes a big difference to how you manage a position, especially when you have a position that includes short options. It's prudent to stay away from settlement risk by exiting positions that have little more to gain - no later than Thursday, the last day those options can be traded.
Differences
There are four key differences between American- and European-style options.
- Underlying
All optionable stocks and exchange-traded funds (ETFs), such as the SPDR Trust (SPY) and the Nasdaq 100 Trust (QQQQ) have American-style options. Among the broad-based indexes, only the S&P 100 index (OEX) has American-style options.
Major broad-based indexes, such as the S&P 500 (SPX), Nasdaq 100 (NDX) and Russell 2000 (RUT), have very actively traded European-style options.
- The Right To Exercise
Owners of American-style options may exercise at any time before the option expires, while owners of European-style options may exercise only at expiration. (For a refresher on exercising and other options fundamentals, see our Options Basics tutorial.)
- Trading
- American options cease trading at the close of business on the third Friday of the expiration month. (A few options are 'quarterlys', which trade until the last trading day of the calendar quarter or 'weeklys', which cease trading Friday of the specified week.)
- European options stop trading one day earlier - at the close of business on the Thursday preceding the third Friday.
- Settlement Price
This is the official closing price for the expiration period and establishes which options are in the money and subject to auto-exercise. Any option that's in the money by $0.01 or more on the expiration date is automatically exercised unless the option owner specifically requests his/her broker not to exercise. (To read more on executing a trade through a broker, see The Nitty-Gritty Of Executing A Trade.)
- American: The settlement price for the underlying asset (stock, ETF or index) with American-style options is the 'regular' closing price, or the last trade before the market closes on the third Friday. After-hours trades do not count when determining the settlement price.
- European: It is not as easy to learn the settlement price for European-style options. In fact, the settlement price is not published until hours after the market opens for trading.
Here\'s how it works:
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Exercise Rights
When you own an option, you control the right to exercise. Occasionally, it may be beneficial to exercise an option before it expires (to collect a dividend, for example), but it's seldom important. (Learn more in Dividends, Interest Rates And Their Effect On Stock Options.)
When you are short an American-style option (you sold the option without owning it) and are assigned an exercise notice prior to expiration, instead of being short the option, you are now short the stock. Unless your account is too small to carry a short stock position, this is not a problem, and if your account is that small, you should probably not be trading options. (Read more in Options Hazards That Can Bruise Your Portfolio.)
The only time an early assignment carries any significant risk occurs with American-style, cash-settled index options. The only such options are OEX, so the easiest way to avoid the early-exercise risk is to avoid trading OEX options. When you receive an assignment notice in the morning, you must repurchase that option at the previous night's intrinsic value. That may place you at serious risk if the market undergoes a significant move, because that forced purchase makes your position different from the one you thought you owned. (To learn more, read Understanding Option Pricing.)
Cash Settlement
It's advantageous to everyone when options are settled in cash:
- No shares exchange hands.
- You don't have to be concerned with rebuilding a complex stock portfolio, because you don't lose your stocks if assigned an exercise notice on calls you wrote, as in covered call writing or a collar strategy. (Read about both of these trading strategies in The Basics Of Covered Calls and Don't Forget Your Protective Collar.)
- The option owner receives the cash value - and the option seller pays the cash value - of the option. That cash value is equal to the option's intrinsic value. If the option is out of the money, it expires worthless and has zero cash value. (To learn more, read Cut Down Option Risk With Covered Calls.)
Settlement Price
With American-style options there are seldom any surprises. When the stock is trading at $40.12 a few minutes before the closing bell on expiration Friday, you can anticipate that the 40 puts will expire worthless and that the 40 calls will be in the money. If you have a short position in the 40 call and don't want to be assigned an exercise notice, you can repurchase those calls. The settlement price may change, and those 40 calls may move out of the money, but it's unlikely that the value of those calls will change significantly in the last few minutes.
With European-style options, the settlement price is often a huge surprise, which may prove beneficial to some, but a disaster for many others. That's because when the market opens for trading on the morning of the third Friday, there is often a gap, a significant price change from the previous night's close. This doesn't happen all the time, but it happens often enough to turn the apparently low-risk idea of holding that position overnight into a large gamble.
When you own the European option, here's the situation you face Thursday afternoon, the day before expiration:
- If the option is almost worthless, holding onto it and hoping for a miracle is not a bad idea. Owners of low-priced options, worth a few nickels or less, have been known to earn hundreds, or even a few thousand dollars, when the market gapped open the following morning. Most of the time those options expire worthless, but an occasional large reward is possible.
- If you own an option that has a significant value - let's say $1,000, or an option premium of $10 - you have a decision to make. The settlement price could make the option worthless or double its value. Do you want to take that risk? That's a decision only individual investors can make for themselves.
- When short an out-of-the-money option, covering is a wise move. With American-style options, you see the stock approaching the strike and can spend a nickel or two to cover. But with European options, there are no warnings. Any out-of-the-money option can move 10 or 20 points into the money - and that would cost $1,000 to $2,000 per option when you are forced to pay the settlement price. It's not worth the risk.
If you decide to trade index options, please be certain you understand the differences between American- and European-style options. More importantly, to avoid a significant loss, it's essential that you understand how the settlement price of European options is determined. It makes a big difference to how you manage a position, especially when you have a position that includes short options. It's prudent to stay away from settlement risk by exiting positions that have little more to gain - no later than Thursday, the last day those options can be traded.
by
Mark Wolfinger
Mark Wolfinger moved to Chicago to become a market maker on the Chicago Board Options Exchange (CBOE) in 1976. He left the CBOE in mid-2000 to concentrate on educating individual investors on conservative investments using options. Since that time he has written three books and numerous magazine articles. His latest book, "The Rookie's Guide to Options: The Beginner's Handbook of Trading Equity Options", is targeted to beginners and shows how options work and how to adopt and manage six different conservative strategies. He writes a blog and has an options educational website.
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