Options trading is the practice of buying or selling options contracts where the buyer has the right to buy or sell the underlying asset like a stock at a certain price by a certain date. At some point in their options trading journey, every investor will run across two kinds of option contracts: American and European. It’s important to understand these different styles and how you can use them to great effect in raking in additional profits from trading options.
While American and European options sound geographical, the terms refer to their exercise rules instead of where you can use each contract, that is before or on the expiration date. But which one gives traders more flexibility, and which one is often cheaper? We’ll cover this and everything else you’ll need to know about these contracts and the subtle differences that could impact your trading activity down the line.
What Are American and European Options?
What’s the main difference between American and European options? There are a few things that set these two types of options apart but it mostly has to do with when investors can exercise the contract. American options give traders much more flexibility when it comes to exercising rights, while European options fail to deliver in that arena. Keep reading to find out what we’re talking about!
American Options
American options are a style of options contract that allows the holder to exercise their rights to buy or sell at any time before and including the expiration date. It’s a common form of options contract in U.S. stock options and ETFs. Holders can profit from favorable stock price movements or dividend announcements. With American options, the holder must pay a premium if they exercise the option early, and the price is evaluated by finding the best time to exercise the contract to experience the maximum payout.
Example
A trader holding an American call option on Apple (AAPL) can exercise it at any time before expiration. Let’s say the expiration is set for December 31st—the trade can exercise the contract anytime before that date or up until that date including the 31st.
European Options
European options are financial contracts that give the holder the right to buy or sell an asset at a predetermined price by a specific future expiration date. Unlike American options, European options only allow the holder to exercise the option on the expiration date and not before. European options are common in index options like S&P 500 (SPX) and foreign markets. They’re commonly used for hedging or speculative purposes.
Example
If you own a European-style call on the S&P 500, you must wait until expiration to exercise. It doesn’t matter which stock you’re holding, the strike price, or any other factors—you can only exercise the contract on its expiration date.
Key Differences Between American and European Options
American and European options differ greatly in terms of their exercise time, flexibility, pricing, settlement style, and availability. We’ve outlined everything below to show you clearly what the main differences are between these two types of option contracts.
Feature | American Options | European Options |
|---|---|---|
Exercise Time | Anytime before expiration | Only on expiration |
Flexibility | Higher | Lower |
Pricing | More expensive | Less expensive |
Settlement Style | Often physical delivery | Often cash-settled |
Availability | Stocks, ETFs, and some indices | Mostly indices and some international markets |
Impact on Trading Strategies
Choosing between American or European options can ultimately have an impact on your trading strategies and techniques as both sets of options differ in their exercise rights, price, flexibility, and a few other factors. While on the surface, European contracts might come across as inherently worse than American contracts, there are some upsides to using them, which ultimately have a positive impact on trading strategy.
Flexibility and Early Exercise
American options offer more control than European options due to the investors having the right to exercise anytime before the expiration as well as on the expiration date. This makes American options ideal for dividend capture strategies or locking in profits early, which is something that isn’t possible for those dealing with European options.
European options force traders to wait, limiting early-exercise advantages. However, the risk of early assignment is eliminated which allows traders to implement hedging strategies with much more confidence than they could with American options.
Pricing Differences
American options tend to be pricier due to early exercise flexibility, while European options are slightly cheaper as they have no early exercise benefit. The price difference is often small because the right to exercise early isn’t worth much.
American options tend to have higher levels of implied volatility and time value because of the added flexibility of early exercise which is what ultimately results in the higher premium. American options are, therefore, more complex to prices and might require binomial model numerical methods.
To learn more about the pricing models that inform American or European options contracts, check out Black-Scholes for European Options and Binomial for American Options.
Risk and Hedging Strategies
When it comes to the risk with each investment and the ability to implement a hedging strategy, American and European options each have their special strengths:
- American Options allow early risk management where traders can exercise if an unexpected price move occurs. However, they are riskier investments for sellers because the holder can choose to exercise them at any time.
- European Options require more planning since exercise is fixed at expiration. European options are better for buyers, though, because it’s easier to create a hedging strategy since the holder knows when they can exercise their right to buy or sell.
When to Use American vs. European Options
There’s a time and place to use American or European options, as each type comes with its own set of pros and cons, which make them ideal in some trading situations and less so in others. Find out when it’s preferable to use American options over European options (and vice versa) to put yourself in the best position possible to succeed with your trades.
When American Options Are Better
- Trading Dividend-Paying Stocks: American options give investors the liberty to choose when to exercise the option, which offers a very clear edge in markets where dividend-paying stocks are involved. This leads to generally better preservation in market dynamics—early exercise is terrific for dividend capture.
- You Need Flexibility to Exercise Before Expiration: This is the obvious choice if there’s a reason you need to exercise the contract before the expiration date as European options don’t offer this as a choice.
- Preference For Individual Stocks Versus Indices: American options are generally not found on indices due to most index options are considered “European-style.” indices are not directly tradable securities so they’re usually settled in cash, unlike American options which involve physical delivery and have a heavier focus on stocks and ETFs.
When European Options Are Better
- Trading Index Options with Cash Settlement: Most index options are presented in “European style” and they are typically settled in cash. When these options are exercised upon the expiration date, cash is exchanged rather than securities.
- Low Premiums: Although it’s only by a small amount, European options come with lower premiums due to not featuring the early exercise option. The higher levels of implied volatility and time value add to the higher premiums found with American options, which aren’t present with European option contracts.
- You Don’t Need Early Exercise: European options don’t offer investors the choice to use early exercise, so European options are best to use with these kinds of trades where you’re looking to settle on the expiration date.
- Using Passive Strategies: If you’re using strategies with a passive approach where exercise timing is less important, you might want to use European option contracts where there’s only one choice: exercising the contract right on the expiration date.
Real-World Example—Trading Scenarios
To give you a better understanding of American and European option contracts in action, we’ve devised two scenarios to illustrate our point. Each example will demonstrate the strength of each option contract and the best scenarios for using each where you can enjoy the maximum benefits.
Scenario 1
An investor holding an American call option on a dividend stock may want to exercise before the ex-dividend date. By doing this, they can become the wonder of the stock and be eligible to get dividend payments. This would not be possible to do if they exercised the options at the ex-dividend date. This makes using an American call option preferable in this situation versus using a European contract.
Scenario 2
A European-style index option trader must wait until expiration to settle the trade. This allows investors to reap profits from index options where there’s no risk of early assignment. It also comes with the bonus of the trader being able to use hedging strategies with a lot more confidence because the right to exercise the option only occurs at expiration, providing a fairly predictable investment.
Common Misconceptions about American and European Options
We’d like to take a moment to address some of the misconceptions that traders commonly have toward the idea of trading American and European option contracts. It’s easy to fall into ideas like American options always being the better choice of getting lower liquidity trading European contracts. However, we’d like to confront these myths with the facts to set the record straight.
Misconception #1
Myth: European options are only traded in Europe.
It can be easy to fall into the belief that you can only use European options when you’re somewhere on the European continent. However, the term “European options” stems from the traditional settlement practices in European markets where options are exercised primarily on the date of maturity and not before.
Fact: They are available in U.S. markets too.
The truth of the matter is that European options are widely available for use in American markets, particularly with index options like S&P 500 (SPX) and foreign markets. Traders in the US can trade European options to their advantage where the risk of early assignment is eliminated and they can implement hedging strategies with a lot more confidence due to their predictability.
Misconception #2
Myth: American options are always better.
Because traders using American options have the ability to exercise their rights at any time before and including the expiration date, it can be easy to believe that American options are inherently better than European options. If that were true, they wouldn’t even use European options in US markets. American options have pros and cons and the same applies to European options as well.
Fact: They cost more and may not always be worth the premium.
American options contracts cost more than European contracts because they allow traders to enjoy early exercise. You’re paying more money to experience that extra level of flexibility. This means that American options that have the same underlying asset and other parameters as European options are more expensive, if even only by just a bit more. In some cases, they aren’t worth the premium paid because they might not produce enough profit for the investor.
Misconception #3
Myth: European options mean lower liquidity.
Because European options can only be exercised on the expiration date, it can create the false idea with some traders that they’re inherently less liquid than American options, meaning that they are most difficult to enter and exit due to their inflexibility. While many European options do indeed have low liquidity, that’s not always the case. There are instances where European options can be more difficult to buy and sell compared to American contracts.
Fact: Many European-style index options have high liquidity.
These options tend to have higher liquidity because they can only be exercised on the expiration date at maturity. These contracts tend to attract a large pool of investors who are looking for more predictable choices in the options market which ultimately leads to minimal price slippage and easier entry or exit points. The high trading volume results in readily available buyers or sellers and narrow bid-ask spreads which makes European index options highly liquid.
Use American or European Options to Meet Your Financial Goals
While American options can be exercised any time before the expiration date, allowing investors to experience a wide degree of flexibility, they come at a higher price than European options and are mostly available on stocks and ETFs (plus some indices) meaning that are often settled through physical delivery.
European option contracts can only be exercised on the expiration date, which ultimately results in little flexibility for the investor, but these contracts are much less expensive to purchase, and their relative predictability results in many of these options being highly liquid. You find options in the European style on indices and some international markets—they are mostly settled with cash.
Consider your trading strategy and take time to examine the current market conditions when choosing which option contract will work most to your advantage. American and European options each have their strengths, so take stock of the current situation to choose the best path forward.
If you’re looking for some beginner-friendly guides to get started with options trading using European and American contracts, visit OptionsTrading.org for a wealth of resources on the subject!
