What Are American And European Options ?

If you are a trader in the F&O market, you must be familiar with concepts like European Options and American Options. Here we look at what are American options and we also look at the European Option definition. Remember, in India both the stock options and index options are European options. However, it was not always like that.

Till 2010, all index options in India were European Options while all stock options were American options. However, post 2010 all options are only European Options in India. Apart from understanding what are American options and European Options, we shall also look at the core European Option definition and the American option definition in financial market parlance. Let us delve deeper into the world of European Options and American Options.

WHAT ARE AMERICAN AND EUROPEAN OPTIONS?

Let us start at a conceptual level. A European option can be exercised only at the expiration date, whereas the American Option can be exercised at any time on or before the expiration date. The right of the option buyer is a lot more powerful in an American option. The global practice is that European options are usually traded over the counter i.e., in the non-exchange traded OTC private market. On the other hand, most of the exchange traded options the world over are American Options. However, in India, all exchange traded options are European options irrespective of whether they are index options or stock options. In the past, stock options used to be American options but now even they are European options just like index options.

Looking at a European Option in greater detail

Let us take the example of a call option to understand European Options better. The European Call Option gives the option holder the right to buy a stock at a pre-determined future date and price. Now, the option holder has the right to exercise the Option only at the expiration date as agreed upon by the two parties to the contract. Let us also turn to a European put option.

A European Put option gives the put option holder the right to sell a stock at a pre-determined future date and price. Like in the case of European call, the option holder of the European put can also exercise the Option only at the expiration date as agreed upon between the buyer and the seller of the option.

However, what needs to be remembered is that although European Options can only be exercised on the expiration date, there is nothing stopping the holder of the option from selling the option in the secondary market, subject to availability of liquidity in the options contract. That is true in the Indian context. For example, when you hold a Reliance July call, you don’t have to wait till the last date. You can easily square off the position in the European call option by taking a opposite position and squaring off your position.

Looking at an American Option in greater detail

While the European option can only be exercised on the date of expiry, the American option can be exercised even on any date before the expiry. The time given to the holder of the American option is much wider. Let us now look at an American call and American put separately.

An American Call option gives the holder of the Option the right to ask for the delivery of the security or stock anytime between the execution date and the expiration date. American call options are usually exercised when they are deep in the money, which means the asset’s price is very much higher than the strike price. American options normally attract higher premiums due to the additional benefit of being exercisable at any time before the expiry of the contract.

On the other hand, the American Put option allows the holder of the Option the right to sell the stock anytime between the execution date and the expiration date when the price of the asset falls below the strike price. An American Put option is typically exercised when it is deep in the money when the asset’s price is very much lower than the strike price.

Again, like in the case of the European option, the American Option can also be reversed in the market subject to availability of liquidity.

Comparing and contrasting European Options and American Options

Here are some key points of difference between an American option and European Options. Let us enumerate.

Let us first look at the meaning. European Option gives the option holder the right to exercise the Option only at the pre-agreed future date and price. On the other hand, the American Option gives the option holder the right to exercise the Option at any date before the expiration date at the pre-agreed price. This applies to calls and to puts.

Then we come to premiums. Since the option holder of a European Option has the right to exercise the Option only on expiration date, premiums tend to be lower. The liberty to exercise the Option at any date prior to the expiration date makes the American Option in more demand, which makes it pricey.

In terms of popularity, European options are less popular and hence traded less frequently compared American options. American options are in high demand since it gives the authority to exercise at any time.

In terms of riskiness, the European Options have a lower risk since the expiration date is fixed, and the loss or profit can be estimated. American options have a higher risk since the option holder of an American option can be exercised at any time. American options are a lot riskier for the writer of the option.

For the buyer of the option, the American option is simpler as the contract can be exercised at any time. This is slightly more complicated for a European option. However, with adequate secondary market liquidity, as in Indian European options, that is not a challenge any longer.

Globally, European options are OTC traded while American options are exchange traded. However, the exception is India where the exchange traded options are all European options only.

While globally American options are more in vogue, in India, European options are doing a good job overall.

DIFFERENCE BETWEEN AMERICAN AND EUROPEAN OPTIONS

An American option is pricey, and the premium is higher than a European option since it gives the option holder the right to exercise the contract at any time after entering the contract and before the expiration date.

Options can be traded on an exchange or over the counter, depending on the counterparties that are involved in the transaction. American options are most sought after by traders since it gives the trader the right to exit the position at the time, which is highly profitable for him/her

HOW IS OPTIONS TRADING DONE?

Options trading happens like any another stock through the normal order book route. Only difference is that the order placement involves more complications like lot size, contract selection, evaluation of intrinsic value etc.