A European option is an option that the investor can only exercise when the contract hits its maturity date. This means the holder may only exercise their rights to sell or buy on the expiration date previously agreed upon.
You’ll find that the majority of indexes use European options for the ease of calculation and accounting practices.
How Do European Options Work?
European options are to be exercised only at the maturity date of the contract. This is in contrast to American options that can be exercised at any point up until to the expiration date.
Essentially, European options tend to be less flexible making them cheaper than American-style options. For clarity, this does not mean you have the inability to exit the contract at hand.
You would still have the ability to exit the contract with benefiting only from the premium cost.
What Is Are European Options Used For?
Most European options are used for exchange-traded indexes. The index price is determined by the stocks opening price and moves simultaneously as its price fluctuates.
Investors use European options due to the fact that they are cheaper and require less accounting. You will find investors often prefer this style due to the fact that it’s easier to strategically utilize portfolio percentages and helps hedge risks.
This is because there is no concern over a buyer exercising the option at any moment.
Why Are European Options Important?
European options are typically less expensive than American options due to the set date to exercise. In turn if an investor is looking to trade with a hands-off approach, it just might be the right choice to go with.
Traders using the European options style prefer this method due to the fact that they only care for the price of the stock/index by expiration.
What Is an Example of a European Option?
So let’s put the concept of European options into an example. Let’s say you want to purchase a put option for ABC index that holds a strike price of $10.
You believe the ABC index will trade at $5 by its expiration on August 15th and you purchase the contract for $1. Now if the contract is trading at $2 by August 1st, this would be a great time to exercise the contract.
But because you are using a European options trading style, you are not able to exercise the contract. Instead you will have to wait until August 15th to exercise.
There is a possibility to get out of the contract and sell the contract on the open exchange, which would allow you to still take profits from the premium price. For example if the contract is on the market for $3, you’re able to make a $2 profit on the premium price.
The other choice you could make is to hold onto the contract until it hits its maturity date. If the contract is still trading below the strike price, you will make profit or breakeven from the premium paid.
European Option Pricing
The most common way European options are priced are by using the Black-Scholes Model (BSM). The Black-Scholes model is a mathematical strategy that is used for pricing options contracts.
By using this strategy, investors can determine the variation of financial instruments. The model calculates prices of options by using the current stock prices, strike price, dividends, interest rate, time until expiration, and volatility.
The Black-Scholes Model is used to calculate only European-style options’ theoretical value. BSM cannot be used to price American options as the model doesn’t take into account the fact that the options can be exercised at any point until maturity.
Variables of European Options
Before diving into the market, it’s important as an investor to determine what factors affect options pricing and availability.
The value of an option derives its price from the underlying assets. For example, if the value of the underlying asset increases, then the call option is set to increase in price and the put will decrease in price, vice versa.
This simply means that the value of the premium directly affects the stock prices movements.
Once a European option reaches maturity, the investor will then need to exercise. Anything done after this day will not be profitable as the option loses all value.
Options trading in the over-the-counter (OTC) market are set on terms determined by the parties involved. All European options trade on the OTC market.
The strike price is the price at which the investor holding the contract will have the right to either sell or buy the option.
Types of European Options
In order to enter into a European trade the buyer and or seller needs to purchase either a put or call option.
European Put Options
European put options enable the investor holding the contract to sell the security only at expiration. If the stock price is trading less then the strike price the investor is then able to profit from the options premium.
Investors are able to sell a specific number of underlying assets at a strike price at expiration, however this would be considered a bearish move.
European Call Options
European call options enable the investor to purchase underlying securities once they meet expiration. When the stock price is trading more than the strike price, the investor is then able to profit from the call option and cover the cost of the options premium.
Investors who hold the contract can purchase a set number of underlying assets at strike price. This can be seen to be a bullish move.
Benefits & Disadvantages of European Options
Deciding if entering into a European option is best for yourself, remember it is based on what your investment goals are. There are both benefits and disadvantages, so let’s determine when European options are beneficial or harmful for investors.
Benefits of European Options
- Lower cost: Compared to American style options, European options are typically less expensive due to limited flexibility.
- Clarity: Because there is a predetermined expiration date, investors have a stable platform to invest into.
- Risk: Because the pricing strategy is simplified and there is less flexibility, it often comes with less risk to investors.
Disadvantages of European Options
- Limited exit point: there is no choice to settle assets early.
- Flexibility: There is less room to exercise options, so if you see your options underlying assets are trading where you want them to and its before expiration, you are unable to exercise.
- Availability: Because European options trade over-the-counter, its not as easily accessible to purchase.
European Options vs American Options
European and American options serve investors with a variety of benefits. Typically though, there are more people looking to trade American options due to the ability to exercise freely.
Meaning, if a stock suddenly rises in price from $5 a share to $10 a share, the trader has the ability to exercise their share at that point. But while there is more flexibility when trading on the American style, the expense to purchase American options is always higher than European options.
With higher expenses to purchase American options, the assets value will have to decrease more in order for investors to receive profits compared to European options.
So Are European Options For You?
European options allow for the investor only to exercise at expiration date. Due to its limited flexibility, it may not work for every investor.
It’s important for traders to understand all trading options styles to determine what works best for their investments. If you are curious about investing in European options, find out what a financial advisor can do for you.