What Is a European Option?
A European option is a version of an options contract that limits execution to its expiration date. In other words, if the underlying security such as a stock has moved in price, an investor would not be able to exercise the option early and take delivery of or sell the shares. Instead, the call or put action will only take place on the date of option maturity.
Another version of the options contract is the American option, which can be exercised any time up to and including the date of expiration. The names of these two versions should not be confused with the geographic location as the name only signifies the right of execution.
- A European option is a version of an options contract that limits rights exercise to only the day of expiration.
- Although American options can be exercised early, it comes at a price since their premiums are often higher than European options.
- Investors can sell a European option contract back to the market before expiry and receive the net difference between the premiums earned and paid initially.
- Investors usually don't have a choice of buying either the American or the European option and most indexes use European options.
- The Black-Scholes option model is often used to value European options.
Understanding a European Option
European options define the timeframe when holders of an options contract may exercise their contract rights. The rights for the option holder include buying the underlying asset or selling the underlying asset at the specified contract price—the strike price. With European options, the holder may only exercise their rights on the day of expiration. As with other versions of options contracts, European options come at an upfront cost—the premium.
It is important to note that investors usually don't have a choice of buying either the American or the European option. Specific stocks or funds might only be offered in one version or the other, and not in both. Most indexes use European options because it reduces the amount of accounting needed by the brokerage.
European index options halt trading at business close Thursday before the third Friday of the expiration month. This lapse in trading allows the brokers the ability to price the individual assets of the underlying index.
Due to this process, the settlement price of the option can often come as a surprise. Stocks or other securities may make drastic moves between the Thursday close and market opening Friday. Also, it may take hours after the market opens Friday for the definite settlement price to publish.
European options normally trade over the counter (OTC), while American options usually trade on standardized exchanges.
Types of European Options
A European call option gives the owner the right to acquire the underlying security at expiry. For an investor to profit from a call option, the stock's price, at expiry, has to be trading high enough above the strike price to cover the cost of the option premium.
A European put option allows the holder to sell the underlying security at expiry. For an investor to profit from a put option, the stock's price, at expiry, has to be trading far enough below the strike price to cover the cost of the option premium.
Closing a European Option Early
Typically, exercising an option means initializing the rights of the option so that a trade is executed at the strike price. However, many investors don't like to wait for a European option to expire. Instead, investors can sell the option contract back to the market before its expiration.
Option prices change based on the movement and volatility of the underlying asset and the time until expiration. As a stock price rises and falls, the value—signified by the premium—of the option increases and decreases. Investors can unwind their option position early if the current option premium is higher than the premium they initially paid. In this case, the investor would receive the net difference between the two premiums.
Closing the option position before expiration means the trader realizes any gains or losses on the contract itself. An existing call option could be sold early if the stock has risen significantly, while a put option could be sold if the stock's price has fallen.
Closing the European option early depends on the prevailing market conditions, the value of the premium—its intrinsic value—and the option's time value—the amount of time remaining before a contract's expiration. If an option is close to its expiration, it's unlikely an investor will get much return for selling the option early because there's little time left for the option to make money. In this case, the option's worth rests on its intrinsic value, an assumed price based on if the contract is in, out, or at the money (ATM).
European Option vs. American Option
European options can only be exercised on the expiration date, whereas American options can be exercised at any time between the purchase and expiration dates. In other words, American options allow investors to realize a profit as soon as the stock price moves in their favor and enough to more than offset the premium paid.
Investors will use American options with dividend-paying stocks. In this way, they can exercise the option before an ex-dividend date. The flexibility of American options allows investors to own a company's shares in time to get paid a dividend.
However, the flexibility of using an American option comes at a price—a premium to the premium. The increased cost of the option means investors need the underlying asset to move far enough from the strike price to make the trade return a profit.
Also, if an American option is held to maturity, the investor would have been better off buying a lower-priced, European version option and paying the lower premium.
Lower premium cost
Allows trading index options
Can be resold before the expiration date
Settlement prices are delayed
Cannot be settled for underlying asset early
Example of a European Option
An investor purchases a July call option on Citigroup Inc. with a $50 strike price. The premium is $5 per contract—100 shares—for a total cost of $500 ($5 x 100 = $500). At expiration, Citigroup is trading at $75. In this case, the owner of the call option has the right to purchase the stock at $50—exercise their option—making $25 per share profit. When factoring in the initial premium of $5, the net profit is $20 per share or $2,000 (25 - $5 = $20 x 100 = $2000).
Let's consider a second scenario whereby Citigroup's stock price fell to $30 by the time of the call option's expiration. Since the stock is trading below the strike of $50, the option isn't exercised and expires worthless. The investor loses the premium of $500 paid at the onset.
The investor can wait until expiry to determine whether the trade is profitable, or they can try to sell the call option back to the market. Whether the premium received for selling the call option is enough to cover the initial $5 paid is dependent on many conditions, including economic conditions, the company's earnings, the time left until expiration, and the volatility of the stock's price at the time of the sale.
There's no guarantee the premium received from selling the call option before expiry will be enough to offset the $5 premium paid initially.