European Style Options
All options contracts use one of two distinctive styles; European style and American style. European style contracts must be exercised on fixed expiration dates, while American style contracts can be exercised at any point. These two terms are applied entirely based on those characteristics, and are not related to geographical reasons.
The cost of owning European style options is generally lower than American style options because they are generally less common. On this page you will find more details about them, including how they are priced and their benefits.
- What are European Style Options?
- Advantages of European Style Options
- Buying & Selling European Style Options
What are European Style Options?
Options contracts come in a wide range of different forms and can be categorized in a number of ways. They can be categorized based on the underlying security they represent or based on how and where they were sold. Then the two main types, calls and puts, come into play. Calls give the holder the right buy a specific security while puts give the holder the right to sell a specific security. There are also more complex types known as exotics. These could include binary options and barrier options.
All of these types can be put into one of the two style categories: American or European. A European style contract, like any other options contract, has two parties involved. The holder of the contract who is the party buying the contract or the right to buy or sell the underlying security. The writer is the one who is providing that right and is obligated to comply should the holder exercise.
The underlying security is specified in the contract, along with the strike price; this is the point at which the contract can be bought or sold if the holder decides to exercise. The contract also contains an expiration date, and it is on this date that the holder must decide whether or not to exercise. This is where European style contracts differ from American style contracts, which can be exercised at any time prior to the expiration date.
Although European style contracts don't offer the same flexibility for exercising as American style contracts, they can still be sold at any time up until the day before expiration so there are still possibilities for locking in profit prior to them expiring. There are a number of trading strategies that European style contracts can be used for. It's also worth noting that the reduced flexibility of European style contracts tends to make them cheaper than American style contracts.
To understand how the price of options is determined, you should be familiar with the terms intrinsic value and extrinsic value. When you see an options contract listed for sale on the exchanges its asking price will essentially be a total of these two components. Only the total price will be listed, but you really need to understand how that price is broken down, and the differences between the two components.
Intrinsic value is the actual inherent value of the contract. If there is profit that is effectively built into a contract when it's offered for sale, then that is the intrinsic value and it's included in the total price of the contract. For example, a call gives the holder the right to buy the relevant underlying security at an agreed fixed price; this is known as the strike price. If the strike price is lower than the price of the security at the time when the contract is bought, then the holder gains some immediate intrinsic value.
A call where the strike price is lower than the price of the security is said to be an in the money contract. If the strike price is equal to the security price, it's said to be at the money. If the strike price is above the price of the security, it's said to be out of the money. For puts, where the holder has a right to sell the relevant security, the terms are actually reversed. An in the money put is when the strike price is higher than the current security price and an out of the money put is when the strike price is lower than the current security price.
It's very useful to understand the distinction between these terms if you are trading options. Only in the money contracts have any intrinsic value. The prices of at the money and out of the money options are made up entirely of extrinsic value.
Extrinsic value is essentially the cost of owning the contract in addition to any intrinsic value that already exists. While the intrinsic value represents a tangible amount of value, extrinsic value is intangible and based on what might or might not happen to the price of the underlying security during the term of the contract.
The extrinsic value of a contract is a representation of the risk being taken by the writer who privded the option. Because there is no flexibility in when European style options can be exercised, the risk to the writer is less than when the holder can exercise at any time. As such, the extrinsic value of European style options is typically less than American style options.
Advantages of European Style Options
The advantages of European style options are really quite simple. When buying a European style contract you will usually save money on the price of the contract, as the extrinsic value component is generally less due to you only being able to exercise at the expiration date. If you are confident that the contract will contain sufficient intrinsic value by that time, then the reduced extrinsic value will effectively increase your profits.
Writers of European style contracts have the advantages of a fixed timeline and less risk being involved because they are not exposed to the possibility of the contracts being exercised before their specific expiration date.
Buying & Selling European Style Options
As European style options tend to be traded over the counter (OTC) rather than on the exchanges, they aren't necessarily as accessible as American style options. However, there are a number of online stock brokers that let you trade OTC products. Using an online broker is probably the easiest and most cost effective to way trade options.