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American and European options have similar characteristics but the differences are important. In this article, we'll discuss their characteristics and how options traders can use this knowledge to avoid costly losses.

Key Differences

There are four key differences between American- and European-style options:

1. Underlying

All optionable stocks and exchange traded funds (ETFs) have American-style options while only a few broad-based.indices have American-style options. Major broad-based indices, including the S&P 500, have very actively traded European-style options.
 

2. 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.
 

3. Trading of index 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.

European index options stop trading one day earlier, at the close of business on the Thursday preceding the third Friday of the expiration month.
 

4. Settlement Price

This 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 1 cent or more on the expiration date is automatically exercised unless the option owner specifically requests his/her broker not to exercise.

  • 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 identify the settlement price for European-style options. In fact, the settlement price is not published until hours after the market opens.

Here's how the European settlement price is calculated:

  • 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. EST 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.

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. 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.

Cash Settlement

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.

Settlement Price

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 worthless 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.

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 thousand 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.

The Bottom Line

European-style options pose special risks for option traders, requiring careful planning to avoid systemic exposure.

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