Exploring European Options

By Douglas Rice AAA

An option is a contract that gives the investor the right - but not the obligation - to buy or sell a specific financial instrument at a specific price and time. With a European-style option, the contract terms allow the option to be exercised only on the expiration date. This differs from an American option, which can be exercised at any point during the contract period. The ability to exercise only on the expiration date is the key element that separates European style options from all other option styles. In this article, we'll introduce European options, contrast them with other types of options and discuss their use.

Although option styles have different geographic names, their distinguishing characteristics have nothing to do with physical geography. Here are some of the basic differences between European and American options:

OTC Versus Exchanges
European options are usually traded over the counter (OTC), although some European index options trade on exchanges. This differs from American options, which typically trade on exchanges. In some cases, such as the CBOE Index Flex options, both American- and European-style options are available. Most index options are European style, and all equity options are American style.

Ease of Exercise
Limited exercise dates remove the uncertainty about possible early execution, a feature that makes the pricing and valuation for European options simpler than more complicated options types, such as American, Asian or Bermuda. While the ability to execute an American option at any time during the contract provides more flexibility, these options cost a bit more than European options, all else being equal. Determining the value of that flexibility makes pricing or valuing American options more complex.

In some cases, European options will trade at a discount relative to their intrinsic value, since the investor must wait to execute the option and receive full value. A deep in-the-money European option that expires in several months may sell at a discounted price compared to fair value. This price is often calculated using the Black-Scholes formula, and it reflects the risk of having to wait to exercise the option. This discrepancy doesn't occur with American options, which investors can execute immediately.

European Vs. Exotic Options
More exotic options, such as Asian or Bermuda options, add even more complexity to valuation and pricing. The pricing of Asian options is based on an average value of the underlying instrument over the specified period of time. By contrast, European options are valued using the specific price of the underlying instrument at a specific point in time, not an average. Bermuda options allow the issuer to call the security at discrete points in time after a certain date, while European options have no call provisions.

Investing Using European Options
Trading any type of option typically requires a margin account through a broker. Once the account is set up, the transaction is similar to any other securities transaction. The investor will communicate the order to the broker and establish the position.

Once an investor buys a European option contract, he or she can exercise it, allow it to expire or sell it. To exercise it, he directs his broker to do so, and the transaction will occur on the date of expiration. Many investors seeking to profit from the exercise but not hold the underlying security long-term will immediately sell the underlying asset to generate a profit. If the investor wants to hold the underlying asset, the execution will require enough capital in the account to actually pay for the underlying asset at the strike price. Typically, investors would only exercise options when the transaction is profitable.

If the price of the underlying asset makes execution unfeasible, the investor can let the option contract expire and limit losses to the cost of the contract. It is very common to let out-of-the-money contracts simply expire.

While investors can close the position prior to the expiration date by selling the options, they cannot execute before the expiration date. This potential outcome allows a continual opportunity to lock in profit or limit losses by closing the position without waiting for expiration or having to execute.

European options carry risks similar to all other option styles' contracts, and there is no guarantee that the underlying instrument will move in a way that creates value in the option. According to the Options Clearing Corporation, 55% of all option positions were closed in sales to others, 17% were exercised and 28% expired unexercised in 2007. Given this breakdown, it is clear that a substantial amount of option contracts are unprofitable.

The Bottom Line
European-style options are very much like other option styles, except that they can only be exercised on their expiration date. This is neither an advantage nor a disadvantage compared to other option styles, but simply an element of the option contract. The European option is the basic option from which other types of options derive, and an understanding of their use will provide an additional alternative for option traders.

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