Introduction
American and European options are the two main styles of options contracts. While they grant the same basic right to buy or sell an underlying asset, American and European options have important differences in how that right can be exercised. Understanding these differences is critical for valuing options properly and managing the risks of an options trading strategy.
Exercise Rights
The key distinction between American and European options is when they can be exercised. American options can be exercised at any time prior to expiration. This allows the owner to exercise early if doing so would realize a profit, such as when the underlying asset pays a dividend. European options can only be exercised at the expiration date itself. This restricts the potential upside of early exercise for the owner.
Due to their early exercise rights, American options are more valuable than otherwise identical European options. There are certain situations where early exercise creates an arbitrage opportunity that guarantees a profit for the owner. Deep in-the-money American call options, for instance, can be exercised early to capture dividends or borrow against the proceeds. However, early exercise is not always optimal. Factors like time value remaining, interest rates, and volatility impact whether exercising makes sense. Generally, early exercise is most advantageous for deep ITM options.
Impact on Valuation
The valuation models for American and European options must account for differences in early exercise rights. American options carry a premium over European options with the same strike and expiration. The valuation premium depends on the time to expiration, volatility, and interest rates. Longer dated options have higher premiums, as there is more time value that may be realized by early exercise. Higher volatility also increases the valuation premium, as it boosts the chance of the option moving deep ITM where early exercise is beneficial.
Examples and Uses
Most stock options are American style, allowing owners to exercise early if optimal. Major stock indexes like the S&P 500 have European style options, restricting exercise to expiration date only. For commodities, futures options are typically American, while options on commodity ETFs are European. Cryptocurrency options also follow the European style in most cases.
American options provide more flexibility for customizing exercise rights. They also carry higher valuations that benefit the owner. European options offer simpler administration without early exercise to consider. Exchanges and brokers can mandate one style or offer both.
Settlement Procedures
Exercising an American option early requires notifying the Options Clearing Corporation via broker. This triggers a process that randomly assigns the exercise to a short option holder who must fulfill their side of the contract. European options at expiration are exercised automatically if they are in-the-money based on the closing price.
For both American and European options, settlement happens the next business day after exercise or expiration. Cash settled options deliver a cash payment, while physically settled options involve delivery of the underlying asset.
Risks and Considerations
Traders writing American options face assignment risk prior to expiration. This includes dividend dates, earnings announcements, and other events that could cause early exercise. Monitoring time value remaining versus intrinsic value can indicate rising early exercise risk. Margin requirements also increase with unanticipated assignment on a short option.
On the other side, buyers of American options should consider the dividends, borrowing rates, and other factors that determine optimal early exercise. While American options provide flexibility, exercising early also forfeits any remaining time value.
Conclusion
While American and European options provide the same basic rights, American options allow customization of exercise timing. This benefits owners but requires close monitoring of early exercise risks for writers. European options are easier to value and administer without early exercise rights. Understanding the implications of both styles is critical for employing options strategies.
Here at CoinCall, option buyers and sellers need not worry about early exercising prior to expiration as all of our contracts are of the European settlement variety. Although the implementation of American-expiry options in the cryptocurrency markets is not the predominant way of settlement, it’s still important to understand the difference between the two types of expiries in the context of options trading.
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