- October 6, 2022
- Posted by: CoachShane
- Category: Trading Article
American and European options contracts are the two main types of options contracts available to traders. American-style option contracts can be exercised at any time up until expiration, while European-style option contracts can only be exercised at expiration.
Understanding the difference between these two types of options contracts is essential when trading options. In this blog post, we will dive into the key differences between American and European options.
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.
Summary
American options can be exercised at any time before expiration, while European-style options can only be exercised at expiration. The flexibility this offers can impact your bottom line especially if there is a huge jump in the underlying. With American style, you can exercise the option but with European, you can only hope that the jump in price holds until expiration.
The settlement price for European-style options is known the Friday morning after expiration, while the settlement price for American-style options is known at the close of trading on the day of expiration. There is a risk of a major overnight event affecting your European-style option holder.
No shares will change hands during the settlement period for European-style options and is all done on a cash basis. 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.
Trading options can be a great way to make money. You can make profits in both up and down markets. And with our 8-minute success formula, you can learn how to trade options quickly and easily.
