What is a European Option?
A European option is a type of options contract that can only be exercised on its expiration date. Unlike American options, which you can exercise before expiration, European options limit you to acting solely on the maturity date.
Many investors opt for European options for trading indices, as they come with lower premiums and can be resold before expiration.
Key Takeaways
- Specific Execution Timing: European options restrict exercise to only the expiration date.
- Lower Premiums: They’re generally cheaper compared to American options, which can be exercised at any time.
- Market Flexibility: Investors can sell a European option back to the market before expiry and capture any premium gains.
- Common in Index Trading: European options are mostly used in index trading, reducing the need for extensive trading and accounting.
- Valuation Method: The Black-Scholes model frequently calculates European options’ value.
Understanding European Options
European options create a clear timeframe for when holders can utilize their rights under the contract, whether it’s buying (‘call’) or selling (‘put’) the underlying asset at the specified strike price. However, these rights can only be exercised upon expiration.
Investors generally don’t get to choose between American or European options when it comes to specific stocks or funds. Typically, most index options are European due to simplified brokerage accounting.
European index options stop trading the Thursday evening before the third Friday of the expiration month. This halt aids brokers in pricing the underlying index components effectively. However, this process can make the settlement price—determined after market close—unexpected.
Most European options are traded over-the-counter (OTC), distinct from the standardized exchange listing of American options.
Types of European Options
Call Option
A European call option provides the owner with the right to buy the underlying security at the strike price upon expiration. The profit is achieved if the security trades sufficiently above the strike price to cover the option premium by expiration.
Put Option
A European put option grants the holder the right to sell the underlying security at the strike price upon expiration. To profit, the security’s price must be sufficiently below the strike price, accounting for the premium paid.
Closing a European Option Early
While European options can’t be exercised before expiry, they can be sold in the open market. Option prices fluctuate based on underlying assets’ volatility and movements, and the premium changes accordingly. If the option’s premium appreciates relative to its original cost, investors can sell the option to lock in profits early.
Essentially, the trade’s profitability online hinges on the intrinsic value and the time left before expiration. Near expiration, the option’s market value relies more on its intrinsic value than on time value.
European Option vs. American Option
European and American options have fundamental differences. European options are exercised strictly at expiration, while American options offer any-time exercise flexibility. This flexibility benefits those holding dividend-paying stocks—allowing early option exercise to own shares pre-dividend payout. However, American options come with higher premiums than their European counterparts.
Investors willing to hold their options positions until maturity might prefer European options to benefit from lower premiums.
European Option Pros
- Lower Cost: Enjoy reduced premiums.
- Index Compatibility: Ideal for trading indices.
- Flexibility to Trade: Options can be resold before expiration.
European Option Cons
- Delayed Settlement: Final prices might be unexpected remnants of post-market close evaluations.
- Fixed Exercise Date: Cannot be exercised early for underlying assets.
Example of a European Option
Consider an investor buys a July call option on Citigroup Inc. at a $50 strike price with a $5 premium per contract (total $500). At expiration, if Citigroup is trading at $75, the investor buys the stock at $50, securing a profit of $25 per share. Post premium calculation, the net profit comes to $20 per share or $2000 total.
In another scenario, if Citigroup’s stock fell to $30 by expiration, the option expires worthless, and the $500 premium is a loss.
An investor doesn’t necessarily need to wait for expiry. They might sell the option early if prevailing market conditions are favorable and the premium rise sufficiently. However, securing gains that offset the initial premium is not guaranteed.
Related Terms: options contract, premium, strike price, volatility, expiration date.
