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Explaining the Differences Between American and European Options

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February 26, 2014 – Comments (0)

 American vs European

Option traders are familiar with basic contract specifications such as strike price and expiration, but some traders may be less familiar with option exercise styles. The most common of these are American and European style, and the major difference between them concerns when the owner of the option is allowed to exercise it. The owner can exercise a European style option only at expiration, but may exercise an American style option at any time prior to expiration as well.

Standard Options

Options on individual stocks and ETFs are almost universally American Style, but options on indices vary. For example, options on the DJX are European style, while options on the OEX are American style. To find an option's exercise style, check the website of the exchange that trades it, e.g. the CBOE or NASDAQ site.

In addition to the rule about when the owner can exercise, certain trading and settlement rules also depend on exercise style. American style options stop trading on expiration Friday, but European style index options stop trading on the day before that. The settlement price of American style options is set by the last trade prior to the close on expiration Friday. The settlement price for European style index options however, is calculated based on the Friday opening prices of the individual stocks comprising the index. Settlement price may determine whether an option is automatically exercised at expiration.

Binary Options

With few exceptions, it doesn't make sense for a trader to exercise standard options, because they would lose any time value reflected in the premium price. Traders generally just sell to close these options, so exercise style is not an issue. In the case of binary options however, exercise style is more important. For high-low type binary options, the payoff is determined by where the underlying price is at expiration. This is equivalent to a European style option in the sense that the trader cannot realize an exercise profit until expiration. For one-touch binary options on the other hand, the trader may see a payoff as soon as the underlying price touches the strike price. This is equivalent to an American style option, because the trader may realize an exercise profit at any time prior to expiration. Check with binary options brokers when you purchase them to make sure your option is exercisable when you need it to be.

Conclusion

The main difference between American and European exercise style concerns when the trader can realize an exercise profit. While not an issue for most traders of standard options, it is of paramount importance for traders of binary options.

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