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You need to be aware of ideas like European and American options if you trade in the F&O market. Here, we examine what constitutes American and European options in detail. Also, remember that both stock and index options are European in India.
Before 2010, all Indian stock options were American, while all index options were European. But as of 2010, European options are only available in India. In addition to learning what American and European options are, we’ll also examine the basic definitions of European and American call option used in financial markets. So, let’s get started: –
What is an American option?
A derivative contract known as an American option can be exercised or redeemed at any time throughout its term or on its maturity date. This implies that the investors or option holders may exercise the option at any time before or following its expiration date. Generally speaking, American options are worth more than their European equivalents, which are restricted to being exercised upon maturity.
If investors exercise their options before they expire, they have to pay more. It’s important to remember that the names listed here have nothing to do with geographic locations, even if people frequently mistake American and European option selections for specific locations.
Types of American options
There are mainly two types of American options. They are:
- American put option
Up until the day of maturity, an investor may execute their American call option whenever they like. This implies that to exercise the option, the investor must select the most advantageous time.
- American call option
In the US, a put option is the exact opposite of a call option. All option holders, however, may choose to exercise their options before or on the date of expiration. Unlike European options, which require the investor to wait until the option expires to exercise, put options allow the investor to do so immediately.
Benefits of American style options
The following are some of the main advantages of purchasing American Style options:
- The main benefit of American options is the ability to exercise the contract at any time before its expiration date.
- the chance to exercise the agreement before the ex-dividend date, which would enable the option holder to keep the stocks and get dividends for the ensuing term.
- It encourages greater market involvement and makes it simpler to optimize profits.
What is a European option?
European options are only redeemable on the day of expiration. Furthermore, they can only be exercised on the day of expiration. This implies that the buyer is locked in and cannot exercise the option before that date. Because they don’t have the same amount of freedom as American options, this also implies that European options are less expensive.
Types of European style options
- European call option
When a European call option expires, its owner is entitled to purchase the underlying securities. The stock price must be trading above the strike price at expiration to benefit from a call option and cover the option premium.
- European put option
The person who owns a European put option can easily sell the underlying security when the expiration date comes. But to take profit from this type the stocks must be traded below the strike price at expiration to cover all the cost of the option premium.
Benefits of European style options
- European options do carry some risk, but not as much as American options. They might be at risk from a variety of sources. That’s why it is vital to proceed cautiously to prevent such risks.
- European options trade concludes at the end of business on the Thursday before the third Friday of the expiration month. This may cause the underlying price to move unexpectedly.
- Determining the settlement price could be challenging because of the risk of trading lapses.
- Investors can’t profit from a favourable price movement by exercising their options.
What is the difference between American and European options?
American and European are the two primary trading methods that are most popular in the options market. Even if they are comparable, traders must recognise that they are also very different from one another. Let’s dissect these differences in a comprehensible and systematic way.
| Feature | American Style Options | European Style Options |
| Exercise Period | Can be exercised at any time before expiration. | Can only be exercised at expiration. |
| Flexibility | Offers more flexibility due to early exercise capability. | Offers less flexibility as it can only be exercised at expiration. |
| Trading Availability | Widely traded in the U.S. market. | Commonly traded in European markets like India. |
| Premium Pricing | Generally priced higher due to added flexibility. | Typically priced lower due to limited exercise flexibility. |
| Risk Management | Allows for more strategic risk management strategies. | Requires different risk management approaches due to limitations. |
| Contract Settlement | Settlement is usually in cash. | Settlement can be in cash or the underlying asset. |
| Investor Preference | Preferred by active traders and those seeking flexibility. | Preferred by investors who prioritise cost efficiency. |
| Common Usage | Common in stock and index options trading. | Common in foreign exchange and index options trading. |
The Bottom Line
Both American and European options are widely used forms of options contracts with varying degrees of risk and flexibility. American options offer additional opportunities for traders to profit from fluctuations in the market, despite their greater premium and risk profile. Conversely, European options are better suited for traders who are risk-cautious because they have a defined exercise date and a lesser premium.
Before choosing a style option, it is critical to comprehend the distinctions between these two categories of alternatives and give serious thought to all relevant considerations. To ascertain which option best suits their trading goals and risk tolerance, traders should conduct independent research and speak with financial professionals.
FAQs
European options are less risky than other options because they have a predetermined expiration date and allow for predicted profit or loss. Because the option holder of an American option may exercise the option at any moment, American options carry a higher risk.
A European option is a kind of options contract where investors can only exercise their options on the contract’s expiration date. The strike price of an option is the amount at which the contract holder is entitled to purchase or sell the underlying securities.
Notably, it wasn’t always like this in India; today, both stock and index options are European. Indian index options were European till 2010; stock options were American. But starting in 2010, every option in India changed to being limited to European options.
The buyer won’t exercise the contract, though, if the asset’s market price is less than the strike price on the expiration date as they won’t make enough money to pay the premium. The agreement will expire null and void.
Assume that if the current price of an ABC share is ₹. 300 and A anticipates that the price will increase to ₹. 350 in a month due to market or economic causes, A may purchase a one-month European Call option contract at a mutually agreed-upon price of, say, ₹. 320.