Options, as we all know, are contracts where the holder/buyer has the right, but there is no obligation to buy or sell an underlying asset at a specific price and at a future date. We do know that options are of 2 types – Call and Put. But, there are three more sub-types of options on the basis of when the holder can exercise an option. These types of options are American, European, and Bermudan options. Let’s discuss the differences between the American vs. European option in this blog.
Before we deal with the differences between the American vs European option, first, let’s take a look at what the two options mean.
The holder of such an option can exercise it on any trading day before the expiry of the option. These are the most popular type of options because they give users flexibility as to when they can exercise the agreement. In the U.S. market, American Options generally have an expiry date of between three months and one year.
Generally, the holder of the American Call Option exercises the option when they are deep in the money. This means the holder will exercise the option when the rate of the security is much more than the strike price. In contrast, an American Put option is deep in the money if the rate of the asset is much below the strike price.
The holder of this option can only exercise it on a specific date, and that date is the expiry date or their maturity date. Or, we can say that the holder of the European Options can’t exercise their contract before the expiry date. So, these options give less flexibility to the holders in exercising the option. Though the holder can’t use the option until expiry, they still have a choice to sell the option to another buyer anytime before the expiry.
American vs European Option – Example
Suppose there are two call options for shares –the American and the European. Both the options have a strike price of $30 and the same expiry date of three months. Suppose the share is currently trading at $25
Now suppose if, after one month, the share price rises to $35. The holder of the American option can exercise the option and buy the share at $30 (strike price) and sell it at $35. This way, they will gain $5.
On the other hand, the holder of the European option won’t be able to exercise the option. The holder will have to wait until the expiry and then decide whether or not he wants to exercise the option.
Now that you have an idea about the two options let’s take a look at the differences between the American vs European options.
Differences between American vs European Option
Following are the differences between the American vs European options:
As said above, the American option gives the holder the right to exercise the option at any time before the expiry date. In contrast, one can exercise the European option only at the expiry date.
The premium for European Option is comparatively lower. This is because holders get only one choice for exercising the European option. The premium for the American Option is comparatively higher. This is because the holders get more options as to when they can exercise the option.
American options are popular among traders because of their freedom in exercising the option. European options are less popular as traders get less freedom.
Coming up with a hedging strategy is relatively easier for the European options. This is because one knows when the holder can exercise the option. In contrast, creating a hedging strategy is challenging for the American options because the holder can exercise the option at any time.
American options usually trade at major exchanges. But, European options trade primarily over the counter (OTC).
Since there is no fixed maturity date for the American options, they carry a higher rate of risk. On the other hand, since the European options have a fixed maturity date, it is easier to estimate their profit or loss. Thus, we can say that European options carry a relatively lesser risk.
Black-Scholes Model, which is the best option pricing model, may not give accurate results for the American options. This is because the model doesn’t consider early exercise or exercise of options before maturity. Black-Scholes Model values each option considering it to be European.
Usually, the majority of the equity options are American options. On the other hand, options involving equity indices are usually European options.
Most American index options expire after the end of the trading hours on the third Friday of the expiration month. There are a few exceptions to this rule. For instance, a few quarterlies options continue to trade until the last trading day of the calendar quarter. Also, weekly options usually end trading on Wednesday or Friday of the agreed week.
In contrast, the European options cease to trade a day before the third Friday of the expiration month. This means such options cease trading after the trading hours on the third Thursday of the expiration month.
For the American options, the settlement price is the closing price on the third Friday of the expiration month. The settlement of the American option isn’t influenced by after-hours trade.
In the European options, determining the settlement price is a bit challenging. Moreover, the settlement price of the European options isn’t out until hours after the market opens on Friday. i.e., a day after their expiry.
|Basis||American Option||European Option|
|Meaning||Right to exercise the option at any time before the expiry date||Can exercise it only at the expiry date|
|Premium||Comparatively higher||Comparatively lower|
|Popularity||More popular||Less popular|
|Trading||Trade at major exchanges||Trade primarily over the counter (OTC)|
|Risk||Higher rate of risk||Comparatively lesser risk|
|Securities||Majority of the equity options||Options involving equity indices|
|Expiration date||After the end of the trading hours on the third Friday of the expiration month||A day before the third Friday of the expiration month|
|Settlement||The settlement price is the closing price||The settlement price isn’t out until a day after their expiry.|
Traders use both American and European options, but the former is more popular than the latter. American option gives investors more flexibility, but they are more costly than the European. So, it is up to the traders to decide what option they want to use by weighing the features and payoff of both.