Options traders must consider several factors when buying and selling options, including the option’s style. While simple on the surface, the differences between American and European options have many implications for traders.
Options are of two types: call and put. A call gives the buyer the right, but not the obligation, to buy an underlying asset at an agreed strike price by the expiration date. Meanwhile, a put option gives the buyer the right to sell an underlying asset at an agreed strike price by the expiration date.
Calls and puts are combined in various ways to create a diversified range of strategies, from hedging to income and more. Options contracts have several details that traders must understand, including when the option can be exercised. Understanding the difference between American and European options is crucial before investing.
American options may be exercised at any point from when they’re issued through the contract’s expiration. European options, on the other hand, can only be exercised at expiration. The difference between the two carries implications for their price and how they’re used.
For example, a trader wants to trade an option contract on the S&P 500. It’s the beginning of March and they have reason to believe that prices will decline by the end of the month. With the expiration date set at March 31, they would select their put strike price, or the price that they believe prices will fall below so that the option expires in-the-money. In this case, they would purchase a put on the S&P 500, SPY 500P 3/31/2025.
The price they pay to purchase the option, the premium, is calculated from the options’ intrinsic value (difference between share and strike prices) and the time value (how long till expiry), and volatility value (how volatile is the security) . If the option is American style, the trader has the right to exercise the put contract at any point before expiration. On the other hand, if the option is European style, they must wait until the expiration date to exercise it.
Flexible Options
Most single-stock and ETF options are American-style, providing greater flexibility for option buyers and sellers in their ability to be exercised at any point. As such, the premiums for American options tend to be higher, with higher trading volumes. On the other hand, most index options are European-style, only exercisable at expiration. It’s important to note that these options may still trade freely up until the day before expiration but cannot be exercised.
The settlement price for American options also varies, depending on when the option was exercised. Generally, the settlement price reflects the price of the underlying asset at the time the option is exercised. European options stop trading the day before their expiration, with the settlement price determined by the opening price the next day. This means European-style options carry overnight risk or potential price dislocations between the closing and opening price.
European options tend to settle in cash at their expiration. While American options can settle in cash, they may also settle in physical assets, requiring one party to provide the underlying asset when exercised. Understanding the differences between American and European options and their implications for traders may allow for better planning and utilization.
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Options are not suitable for all investors. Investing in options carries substantial risk and tax consequences. Investors may realize losses on any investments made utilizing leverage. Future returns are not guaranteed, and use of leverage may magnify trading losses.
This article is prepared as a general source of information and is not intended to provide legal, investment, accounting, or tax advice, and should not be relied upon in that regard. If legal or investment advice or other professional assistance is needed, the services of a competent professional should be obtained. Information contained in this article does not constitute and shall not be deemed to constitute advice, an offer to sell/purchase, or as an invitation or solicitation to do so for any entity. The content of this article is based on sources believed to be reliable, but its accuracy cannot be guaranteed. BMO InvestorLine Inc. and its affiliates, sponsors and employees do not accept responsibility for the content and make no representation as to the accuracy, completeness, or reliability of the content and hereby disclaims any liability with regards to the same. Any strategies discussed, including examples using actual securities, quotes, and price data, are strictly for illustrative and educational purposes only and are subject to change without notice. BMO InvestorLine Inc. is not responsible for the information provided and disclaims all liability with regards to the same.
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