A European option is an options contract that limits investors to exercising the option only on its expiration date. Options give the contract holder the right to buy or sell the underlying security for a set price, called the option’s strike price.
European options are less flexible than their counterpart, American options, but are more predictable. This article will cover how European options work and how investors can add them to their portfolios.
Definition and Examples of a European Option
A European option is a style of options contract that only allows the option holder to exercise the option contract on the option’s expiration date. Options holders have the right to exercise the option but are not obligated to do so. They can also choose to let the option expire without exercising it.
For example, on Jan. 1, if an investor buys a European put option for XYZ with an expiration date of June 30 and a strike price of $50, they will not be able to exercise that option until June 30. If the price of XYZ falls below $50, it would be profitable to buy the shares on the market and exercise the option to sell them for $50, locking in a profit. However, the option holder must wait until June 30 to have the choice of whether to exercise the contract or not.
In order to profit from the European option before the expiration date, the option holder would need to sell the option to someone else for a premium greater than the premium they paid.
If XYZ rises back above $50 before the expiration date, the investor will likely not exercise it as doing so would guarantee a loss. Even if at some point during the life of the contract exercising the option would have been profitable, the contract holder could not exercise it.
This makes European options less complicated than other types of options. Options sellers don’t have to worry about the option getting exercised early. Similarly, the options buyers don’t have to spend time trying to determine the optimal time to exercise the contract. They simply wait until the expiration date to decide.
European Option vs. American Option
American options are the primary alternative to European options. The main difference between the two is when the option holder is able to exercise the contract.
|European Option||American Option|
|Exercisable only on the expiration date||Exercisable any time before the expiration date|
|Less flexibility means they are generally worth less and have a lower premium compared to American options||More flexibility means they are generally worth more and command a higher premium compared to European options|
|Typically some index options available in the U.S. are European options||Typically most U.S. stock options are American options|
|Typically traded in the over-the-counter (OTC) market||Typically traded on exchanges|
While the holder of a European option can only exercise it on the option’s expiration date, an American option can be exercised at any time between when the option is sold and when it expires.
This makes American options far more flexible. The holder of the contract can choose to exercise the option as soon as it becomes profitable to do so, meaning they don’t need to worry that the price of the underlying security will change and make it unprofitable to do so when the expiration date arrives.
In general, American options command a high premium due to flexibility. Options holders benefit from the ability to exercise the option at will.
Options sellers must deal with the reduced predictability, as they have to be prepared for the option to be exercised at any time. This lets them charge higher prices when selling options.
Pros and Cons of a European Option
More predictable for options sellers
Options are less expensive to purchase
Generally sold over the counter
Options buyers have less flexibility
- More predictable for options sellers. Because options holders can only exercise European options on the expiration date, options sellers don’t have to worry about being ready for the options to get exercised early.
- Options are less expensive to purchase. European options are generally less expensive than American options, giving options buyers the ability to purchase more contracts with the same amount of money.
- Generally sold over the counter. European options are generally not sold over exchanges, meaning they’re less liquid and may take longer to buy and sell than American options.
- Options buyers have less flexibility. If you hold a European option, you have less flexibility when it comes to exercising the option, meaning you might miss out on an opportunity to profit that you could have capitalized on had you purchased an American option.
What It Means for Individual Investors
When buying and selling options, investors need to pay attention to the type of option they’re trading. European options are more predictable, which can be advantageous for options sellers. But, American options offer the flexibility of early exercise, which could be advantageous for option buyers.
It is almost never recommended to exercise early, an American call option on a non-dividend-paying stock. That means the flexibility that the investor paid a higher premium for, is not really used. That could make a case for opting for a European option instead.
However, buyers should keep in mind the restrictions on when they can exercise the contract as it can affect the profit potential of the option.
- European options can only be exercised on the expiration date.
- European options tend to be worth less than more flexible options contracts.
- Options buyers can only profit before the expiration date by selling the contract to someone else.