American and European Options – The Difference

American and European options differ primarily in their exercise timing. American options can be exercised anytime before expiration, offering flexibility to lock in profits when market conditions are favorable. European options can only be exercised on their expiration date, with settlement occurring the following morning. American options dominate U.S. markets and typically carry higher premiums due to their flexibility, while European options are common in index trading. Understanding these key differences helps investors/traders make smarter trading decisions.

Quick Overview

• American options can be exercised anytime before expiration, while European options can only be exercised on expiration date.
• American options typically have higher premiums due to their early exercise flexibility.
• American options settle at market close on expiration day, whereas European options settle the following morning.
• American options dominate U.S. stock markets and are popular with retail traders, while European options are common in European indices.
• American options may involve physical delivery of assets, while European options typically use cash settlement.

American Options

The most popular type of options contract in North America is the American style, which expires on the third Friday of each month (there are also quarterlies and weekly expirations). All individual stocks are traded using American-style options and can be exercised before the date of expiration.

Options contracts that are in the money at the time of expiration will be automatically exercised by the broker unless instructions are given not to.

If the contract is exercised:

• The buyer of a call buys the shares of the underlying at the strike price
• The seller of the call sells the shares to the contract holder at the strike price
• If you are the buyer of a put, you will sell the shares at the strike price
• If you are the seller of a put, you will be buying the shares at the strike price

As an example, assume today is the expiration date for an Options contract of stock ABC in which you were a buyer of a call. The strike price you chose was $140.00.

If ABC closes in the money (the underlying price of $140.01 +), the call buyer will pay $14,000 for 100 shares of ABC stock. The seller of the call, will receive $14,000 in return for the 100 shares of ABC stock that is transferred to the call buyer.

Imagine you are the buyer of a put option, let’s use the same strike price of $140.00. On the day of expiration, the current market price is $139.99 or lower, the owner of the put option receives $14,000 for 100 shares of ABC stock. The seller of the put pays $14,000 and receives the 100 shares of ABC stock.

With American style options, you can be confident that barring any sudden turn, if you are in the money near market close on expiration day, that will be the settlement price or close.

European Options

Options on the major indexes such as SPX and NDX, are European-style options.  One major difference is these options can only be exercised at expiration as opposed to any time prior as with American.

The expiration of these contracts is the close of the Thursday trading session the day before the third Friday of the month, that is one day earlier than American. While the settlement price of American options is known at the close, European options settlement is known Friday morning.

There is a risk that a major event can happen during the evening between the two days. This can result in a shocking settlement price that next day. For a slightly out-of-the-money option, it could put you into profit while the reverse is true for an in-the-money holder.

Unlike American-style stock options, no shares will change hands during the settlement period.  If you own an option that has intrinsic value, that value is deposited into your account.  A seller of that option will have those funds removed from their trading account.

Assume the settlement price of SPX (strike price of $3800) is $3805.00.

If you are the owner of a call option, you would receive:

($3805.00 – $3800.00) X 100 = $500.00.  The seller of that call option would pay you $500.00.

If these were puts, the owner would receive nothing and would be out the premium paid for this contract.

The seller of the put pays nothing but will keep the premium they received.

Choosing the Right Option Type for Your Portfolio

When building an investment portfolio, selecting between American and European options requires consideration of several key factors. The choice depends on your investment goals, risk tolerance, and trading style.

• American options offer more flexibility with anytime exercise, ideal for active traders who monitor markets closely.
• European options typically have lower premiums, making them cost-effective for long-term strategies.
• American options work well for stocks paying dividends, as early exercise can capture dividend payments.
• European options suit index trading due to cash settlement features.
• American options provide better protection against sudden market moves due to exercise flexibility.

Market Availability and Trading Volumes

Market availability for options trading shows distinct patterns between American and European-style contracts.

American options dominate the U.S. markets and are widely available for individual stocks, ETFs, and commodities. They’re especially popular among retail investors due to their flexibility and familiarity.

European options are more commonly found in European markets and are frequently used for index trading, like the S&P 500 (SPX) and Nasdaq-100 (NDX).

While their trading volume is generally lower than American options, they remain important instruments for institutional investors and market professionals who like their predictable settlement features and cash-based settlement structure.

Your Questions Answered

Can You Convert American Options to European Options After Purchase?

Options contracts cannot be converted between American and European styles after purchase. They remain in their original form until expiration or exercise, maintaining their distinct exercise rules.

How Do Dividend Payments Affect American Versus European Option Values Differently?

Dividend payments reduce American option values more significantly since early exercise becomes attractive before ex-dividend dates. European options experience less impact since exercise timing is fixed at expiration.

Which Option Type Has Lower Commission Fees and Transaction Costs?

Transaction costs and commission fees typically vary by broker rather than option type. European options may have slightly lower costs due to less frequent trading and simpler exercise procedures.

Are There Tax Implications Differences Between American and European Options?

Tax treatment is generally the same for both option types, with profits taxed as capital gains and losses deductible according to local tax regulations and holding periods.

Can Institutional Investors Freely Trade Both Types in All Global Markets?

Institutional investors face varying restrictions across global markets. Regulatory frameworks, exchange rules, and local market requirements determine which option types can be traded in specific jurisdictions.

Summary

American and European options serve different investment needs through their distinct exercise rules and pricing structures. While American options provide greater flexibility with their anytime exercise feature, European options often come with lower premiums and simpler valuation models. Investors should carefully consider their trading goals, risk tolerance, and market conditions when choosing between these two option types to build an effective investment/trading strategy.