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What Is a European Option?
A European option is a financial contract that can only be exercised on its expiration date. This is in contrast to an American option, which allows the holder to exercise it at any time before it expires. Most index options are European, which means they can’t be exercised early. The Black-Scholes model is commonly used to value European options and assess their fair price.
Key Takeaways
- European options are exercised only on their expiration date, which typically results in lower premiums compared to American options that offer more flexibility but at a higher cost.
- Despite the exercise limitations, European options can still be sold back to the market before expiration, allowing investors to potentially profit from price movements.
- The Black-Scholes model is commonly used to value European options, offering a mathematical framework for pricing based on factors such as volatility and time to expiration.
- European options generally trade over-the-counter, in contrast to American options, which are often transacted on standardized exchanges.
- Most index options are European options due to the reduced accounting complexity they offer for brokerages.
How European Options Work
European options define the timeframe when holders of an options contract may exercise their contract rights. The rights for the option holder include buying the underlying asset or selling the underlying asset at the specified contract price—the strike price. With European options, the holder may only exercise their rights on the day of expiration. As with other versions of options contracts, European options come at an upfront cost—the premium.
Investors often can’t choose between American or European options. Specific stocks or funds are typically available in only one version, not both. Most indexes use European options because it reduces the amount of accounting needed by the brokerage.
European index options halt trading at business close Thursday before the third Friday of the expiration month. This lapse in trading allows the brokers the ability to price the individual assets of the underlying index.
This process can make the settlement price surprising. Stocks might have drastic price changes between Thursday’s close and Friday’s market opening. Also, it may take hours after the market opens Friday for the definite settlement price to publish.
European options typically trade over the counter (OTC), whereas American options are usually on standardized exchanges.
Different Types of European Options: Calls and Puts
Call
A European call option gives the owner the right to acquire the underlying security at expiry. For an investor to profit from a call option, the stock’s price, at expiry, has to be trading high enough above the strike price to cover the cost of the option premium.
Put
A European put option allows the holder to sell the underlying security at expiry. For an investor to profit from a put option, the stock’s price, at expiry, has to be trading far enough below the strike price to cover the cost of the option premium.
How to Close a European Option Before Expiry
Typically, exercising an option means initializing the rights of the option so that a trade is executed at the strike price. However, many investors don’t like to wait for a European option to expire. Instead, investors can sell the option contract back to the market before its expiration.
Option prices change with the movement and volatility of the underlying asset and time until expiration. As stock prices fluctuate, the option’s premium also changes in value. Investors can unwind their option position early if the current option premium is higher than the premium they initially paid. In this case, the investor would receive the net difference between the two premiums.
Closing the option position before expiration means the trader realizes any gains or losses on the contract itself. An existing call option could be sold early if the stock has risen significantly, while a put option could be sold if the stock’s price has fallen.
Closing the European option early depends on the prevailing market conditions, the value of the premium—its intrinsic value—and the option’s time value—the amount of time remaining before a contract’s expiration. If an option is close to its expiration, it’s unlikely an investor will get much return for selling the option early because there’s little time left for the option to make money. In this case, the option’s worth rests on its intrinsic value, an assumed price based on if the contract is in, out, or at the money (ATM).
Comparing European and American Options
European options can only be exercised on the expiration date, whereas American options can be exercised at any time between the purchase and expiration dates. In other words, American options allow investors to realize a profit as soon as the stock price moves in their favor and enough to more than offset the premium paid.
Investors use American options with dividend-paying stocks to exercise the option before the ex-dividend date. The flexibility of American options allows investors to own a company’s shares in time to get paid a dividend.
However, the flexibility of using an American option comes at a price—a premium to the premium. The increased cost of the option means investors need the underlying asset to move far enough from the strike price to make the trade return a profit.
Holding an American option to maturity means the investor could have saved money with a lower-priced European option.
Practical Example: How European Options Are Exercised
An investor buys a July call option for Citigroup Inc. with a $50 strike price. The premium costs $5 per contract, totaling $500 for 100 shares. At expiration, Citigroup is trading at $75. In this case, the owner of the call option has the right to purchase the stock at $50—exercise their option—making $25 per share profit. When factoring in the initial premium of $5, the net profit is $20 per share or $2,000 (25 – $5 = $20 x 100 = $2000).
Let’s consider a second scenario whereby Citigroup’s stock price fell to $30 by the time of the call option’s expiration. Since the stock is trading below the strike of $50, the option isn’t exercised and expires worthless. The investor loses the premium of $500 paid at the onset.
The investor can wait until expiry to determine whether the trade is profitable, or they can try to sell the call option back to the market. Whether the premium received for selling the call option is enough to cover the initial $5 paid is dependent on many conditions, including economic conditions, the company’s earnings, the time left until expiration, and the volatility of the stock’s price at the time of the sale.
There’s no guarantee the premium received from selling the call option before expiry will be enough to offset the $5 premium paid initially.
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