European option (derivative)

What is a European Option?

A European option is a type of options contract that restricts the execution of the option to its expiration date. Unlike American options, which can be exercised at any time up to and including the expiration date, European options have a key difference: the option holder cannot exercise the option prior to the expiration date. This means that whether it's a European call option or a European put option, the execution of the call or put action can only occur on the specific maturity date of the option.

It's important to note that the terms American and European options should not be confused with geographic locations. These names simply indicate the right to exercise the option, with European options having a later exercise date compared to their American counterparts.

In summary, European options offer the option owner the right to exercise the contract only at its specified maturity date, which sets them apart from American options, which can be exercised at any time prior to expiration. These rights include the ability to either purchase or sell the underlying asset at a predetermined price, known as the strike price.

European Option Explained

The distinguishing feature of European options is that the holder can only exercise these rights on the exact expiration date specified in the option contract. Just like other types of options, European options come with an initial cost known as the option premium, which is paid by the option holder.

One important aspect to consider is that investors often do not have the flexibility to choose between American or European options for a given stock or fund. Certain securities may be available in only one version, either American or European, and not both. In the case of indexes, European options are commonly used. This choice is driven by the simplification it offers in terms of accounting for brokers.

When dealing with European index options, trading ceases at the close of business on the Thursday preceding the third Friday of the expiration month. This break in trading gives brokers the opportunity to calculate the values of the individual assets comprising the underlying index.

As a result of this process, the settlement price of the option can sometimes be unexpected. The prices of stocks and other securities may experience significant fluctuations between the Thursday closing and the opening of the market on Friday. Moreover, it may take several hours after the market opens on Friday for the precise settlement price to be established and published.

Typically, European options are traded over the counter (OTC), which means they are customized contracts negotiated directly between parties, while American options are usually traded on standardized exchanges, offering a more liquid and easily tradable market.

Advantages and Disadvantages of European Options

Advantages

1. More Predictable for Options Sellers. European options are more predictable for options sellers because they can only be exercised on the specific expiration date. This predictability means that options sellers do not need to be constantly prepared for early exercise, reducing the potential for unexpected assignments.
2. Lower Cost. European options are generally less expensive to purchase compared to American options. This lower cost allows options buyers to acquire more contracts for the same amount of money, potentially increasing their exposure to the underlying asset.

Disadvantages

1. Sold Over the Counter (OTC). European options are typically sold over the counter (OTC), which means they are not traded on standardized exchanges. As a result, they tend to be less liquid and may take longer to buy and sell compared to American options. This lack of exchange trading can limit market access and make it harder to find a counterparty.
2. Reduced Flexibility for Options Buyers. Holding a European option comes with less flexibility in terms of when it can be exercised. Unlike American options, where you can exercise at any time before or on the expiration date, European options can only be exercised on the expiration date. This reduced flexibility means that options buyers may miss out on opportunities to profit from favorable price movements that they could have capitalized on if they had chosen American options.

Pricing of European Options

The pricing of European options is influenced by several key factors. These factors include the current market price of the underlying asset, the strike price, the time remaining until the option's expiration, the level of implied volatility in the underlying price, the prevailing risk-free interest rate, and the expected dividends from the underlying asset.

A European put option becomes more valuable when the market price of the underlying asset is lower, especially if it moves further "in the money." Additionally, a higher strike price in relation to the market price increases the intrinsic value of the put option. More time until the option's expiration also adds to its value, as it provides a greater opportunity for the asset's price to decrease. High implied volatility in the underlying asset's price increases the option's value, reflecting the potential for greater price movements. A higher risk-free interest rate slightly enhances the value of European put options due to discounted present value, and expected dividends from the underlying asset have a slight reducing effect on the value of the put option. These factors collectively contribute to the determination of the price of European options.

Examples of a European Option

• Example 1. An investor purchases a European call option on Citigroup Inc. with a strike price of $50 and a premium of $5 per contract (100 shares), resulting in a total cost of $500 ($5 x 100 = $500). At the option's expiration, Citigroup's stock price is trading at $75. In this case, the owner of the call option has the right to buy the stock at the $50 strike price by exercising their option. This leads to a profit of $25 per share ($75 - $50), and after factoring in the initial premium of $5, the net profit per share is $20. Multiplying this by the 100 shares in the contract results in a total profit of $2,000 ($20 x 100 = $2,000).
• Example 2. In a different scenario, Citigroup's stock price drops to $30 by the time of the call option's expiration, which is below the $50 strike price. Since European options can only be exercised on the expiration date, and it's not financially advantageous to buy the stock at $50 when it's trading at $30, the option isn't exercised and expires worthless. In this case, the investor loses the entire premium of $500 that was paid at the beginning of the trade. Additionally, the investor has the option to sell the call option back to the market before expiration, but whether the premium received for selling the call option is enough to offset the initial $5 premium paid depends on various factors, including economic conditions, the company's earnings, the time left until expiration, and the volatility of the stock's price at the time of the sale. There's no guarantee that the premium received from selling the call option before expiry will be sufficient to cover the initial premium paid.