Option is a derivative contract that gives its holder the right to buy or sell the underlying asset at an agreed price and agreed time. We have two different styles of exercising options: American style and European style.
Both styles specify when the option contract can be exercised by the buyer and have nothing to do with a geographic region.
Options are either calls or puts.
A contract that gives the right to buy the underlying asset to the owner is known as a call option. A put option contract gives the owner or buyer the right to sell. The upfront fee paid to buy the right in both call and put option contract is known as premium.
In both call and put, buyers have the right to exercise the option but are not obliged to do so.
Value of an option contract is derived from an underlying asset such as stock, ETFs, crude oil, agri commodities, natural gas, index and currencies.
Option contracts based on american style are known as American options and contracts written based on european style are referred to as European options.
The difference between European style option contracts and American style option contracts is when they can be exercised. American styles can be exercised anytime before expiration. Whereas European styles can only be exercised at expiration.
Which means, the holder or buyer of the European style option contract does not have the right to exercise the contract prior to expiration. In American style option contract, the buyer or holder has more flexibility.
For example, if you bought an european option for XYZ limited with an expiration date of April 25th and at a strike price of Rs 100, then you will not be able to exercise your rights on the contract until April 25th.
However, as these contracts are traded in exchanges, you can sell your right on the option contract at a higher or lower premium based on market price of the underlying asset to another buyer who is interested to buy the right of that contract. After selling, the new buyer will be the owner.
If you want to exercise your rights on the option contract, then you have to wait till 25th April expiry.
Suppose you bought an American call option of PQR limited with a strike price of Rs 100 on 1st January. The option expires on 25th January. If the price of PQR limited increases up to your expectation, then you can choose to exercise the option contract at any time between 1st January and 25th January.
In the US, they follow both American and European option styles. U.S. equity options are American and index options are European style. You can check the style in the contract before trading.
In India, we follow European Style. In the naming convention of the contract you will find letters written as CE or PE, CE means Call European style and PE means Put European style.
Please remember, as a trader you will not have the option to choose between American and European style. But you have to understand the difference as your contract expiry depends on which style of contract you are trading.
European style options vs. American style option example
Let’s look at an example to understand the difference between the European style option and the American style option.
Suppose Mr Kumar purchases an American call option in the month of February with expiry on the last Thursday in the month of April. As per his call option contract, he can purchase 250 stocks of ABC limited for Rs 100 per share.
Rs 100 is the strike price, as this is the price at which the call option can be exercised by Mr Kumar.
Stock prices of ABC limited continue to rise. In the month of March prices reached Rs 150 per share. Due to this price rise, Mr Kumar exercises his option and purchases 250 shares of the stock of ABC limited at Rs 100 per share (strike price) for Rs 25,000.
As the market price is Rs 150, Mr Kumar sell his shares at Rs 150 per share to pocket Rs 12,500 as profit ((Rs 150*250) – (Rs 100*250)).
In this case, Mr Kumar exercised his rights before the expiry in the month of March as the contract is American style.
Suppose instead of American, if the option contract purchased by Mr Kumar was a European style, then he could not have exercised it in the month of March as the expiry date was last Thursday of April. In order to exercise his rights, he has to wait till expiry. What can Mr Kumar do in this case?
If Mr Kumar thinks that prices of ABC limited will not move further or may come down before the expiry, then he can sell his rights on the call option to another buyer in exchange. In this case, Mr Kumar who paid lessor premium while buying the contract will be able to get more premium as the underlying asset prices have increased. The difference in premium amount will be his profit.
Due to better flexibility, American style contracts are generally priced higher compared to European style contracts.
Key takeaways
- European style option contracts can be exercised only at expiration.
- American style option contracts can be exercised at any time prior to expiration.
- American options are more flexible than European ones as the holder of the contract can choose to exercise the option as soon as it becomes profitable to do so.
