American vs. European Options: An Overview
American and European options have similar characteristics but the differences are important. For instance, owners of American-style options may exercise at any time before the option expires. On the other hand, European-style options may exercise only at expiration.
- Most stocks and exchange-traded funds have American-style options while equity indices, including the S&P 500, have European-style options.
- European index options stop trading one day earlier, at the close of business on the Thursday preceding the third Friday of the expiration month.
- The settlement price is the official closing price for the expiration period, establishing which options are in the money and subject to auto-exercise.
Options are contracts that derive their value from an underlying asset or investment. Options give the owner the right to buy or sell the underlying asset (such as a stock), at a fixed price (called the strike price), on or before a specific expiration date in the future. A call option gives the owner the right to buy a stock, for example, while a put option gives the owner the right to sell the stock. The up-front fee (called the premium) is what the investor pays to purchase the option.
Typically, stock options are for a single stock, while index options are based on a basket of equities that can represent the equity market as a whole or a portion of the market, such as a specific industry. A stock option can be exercised before its expiration date (if it's American-style), while an option on an index can only be exercised on its expiry (if it's European-style). However, investors can unwind an option position by selling it before its expiry, including European-style options, though there could be a gain or loss between the premiums paid and received.
All optionable stocks and exchange-traded funds (ETFs) have American-style options while only a few broad-based indices have American-style options. American index options cease trading at the close of business on the third Friday of the expiration month, with a few exceptions. For example, some options are quarterlies, which trade until the last trading day of the calendar quarter, while weeklies cease trading on Wednesday or Friday of the specified week.
The settlement price is the official closing price for the expiration period, establishing which options are in the money and subject to auto-exercise. Any option that's in the money by one cent or more on the expiration date is automatically exercised unless the option owner specifically requests their broker not to exercise. 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.
Explaining American and European Options
With American-style options, there are seldom surprises. If the stock is trading at $40.12 a few minutes before the closing bell on expiration Friday, you can anticipate that 40 puts will expire worthlessly and that 40 calls will be in the money. If you have a short position in the 40 call and don't want to be hit with an exercise notice, you can repurchase those calls. The settlement price may change and 40 calls may move out of the money, but it's unlikely the value will change significantly in the last few minutes.
European index options stop trading one day earlier, at the close of business on the Thursday preceding the third Friday of the expiration month.
It is not as easy to identify the settlement price for European-style options. In fact, the settlement price is not published until hours after the market opens. The European settlement price is calculated as follows:
- On the third Friday of the month, the opening price for each stock in the index is determined. Individual stocks open at different times, with some of these opening prices available at 9:30 a.m. ET while 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 because you cannot look at the published index and assume the settlement price is close in value.
European-style options pose special risks for options traders, requiring careful planning to avoid systemic exposure.
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. Dividends are cash payments paid to shareholders by companies as a reward to investors. When you sell an American-style option, you sell the option without owning it and are assigned an exercise notice before expiration and are short the stock.
The only time an early assignment carries significant risk occurs with American-style cash-settled index options, suggesting the easiest way to avoid early-exercise risk is to avoid American options. If you receive an assignment notice, you must repurchase that option at the previous night's intrinsic value, placing you at serious risk if the market undergoes a significant move.
It's advantageous to all parties when options are settled in cash:
- No shares exchange hands.
- You don't have to worry about rebuilding a complex stock portfolio because you don't lose active positions if assigned an exercise notice on calls you wrote, as in covered call writing or a collar strategy.
- 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.
These cash-settled options are almost always European-style and assignment only occurs at expiration, thus the option's cash value is determined by the settlement price.
The settlement price is often a surprise with European-style options because, when the market opens for trading on the morning of the third Friday, a significant price change may occur from the previous night's close. This doesn't happen all the time but it happens often enough to turn the apparently low-risk strategy of holding the position overnight into a gamble.
Here's the scenario faced by European option traders Thursday afternoon on the day before expiration:
- If the option is almost worthless, holding on and hoping for a miracle is not a bad idea. Owners of low-priced options, worth a few nickels or less, have earned hundreds or thousands of dollars when the market shifted higher or lower on Friday morning. However, these options expire worthless most of the time.
- If you own an option that has a significant value, you have a decision to make. The settlement price could make the option worthless or double its value. Do you want to roll the dice? It's a risk-based decision that individual investors need to make for themselves.
When short the option, you face a different challenge:
- 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, costing $1,000 to $2,000 per contract when forced to pay the settlement price. It's just not worth the risk.