The two styles are used for different underlying assets and trading strategies. They also have different tax implications.
What’s the Difference Between American and European Options?
While the primary difference between European and American options is when they can be exercised, it is not the only way the two differ. Options are called “derivatives” because their value is derived from an underlying asset, which is another financial product such as a stock, exchange-traded fund (ETF), or a commodity such as gold.
Exercise
The holders of American-style options can exercise their right to buy or sell a stock or ETF anytime before the expiration date of the contract. European contracts may only be exercised on the expiration date.
Settlement
When American options are exercised, the stock or ETF actually changes hands from the seller to the buyer. When European options are exercised, only cash changes hands, because the value of the option is based on the changes in a financial index rather than the price of a stock, ETF, or commodity.
Tax Treatment
American option and European option taxation can vary based on the holding period and the complexity of your transactions. In general, the options’ holding period determines whether the option receives short-term or long-term capital gains treatment. Some European index options may qualify for more favorable tax treatment even if held for less than one year. Under Section 1256 of the U.S. tax code, some index options may be taxed at 60% long-term and 40% short-term capital gain rates.
American-Style Options vs. European-Style Example
Under most circumstances, investors don’t get to choose the option style. Individual stocks and ETFs are American style; indexes, with few exceptions, are European style. There is, however, one strategy where investors can decide which style is most attractive to them. Investors who want to buy or sell options based on the S&P 500 have two choices: They can buy options on Exchange Traded Funds (ETF) that own all of the individual securities in the index, such as the SPDR S&P 500 ETF (symbol SPY); or they can invest in something such as the S&P 500 Index Options (symbol SPX) on the Chicago Board Options Exchange (CBOE). Here’s a quick comparison of the two styles: The Standard & Poor’s 100 Index Options (OEX) offers both American-style and European-style options.
The Bottom Line
The difference between American-style and European-style options is when they can be exercised, the underlying assets they are used for, and their tax treatment. Most of the time, the option style is predetermined. Options can be very rewarding, but they also have a high level of risk. Be sure you understand how they work and what the consequences of each move may be before you invest. And of course, do your research, study the fundamentals, and form solid opinions about the expected moves of the underlying securities before you engage in any options contracts. Want to read more content like this? Sign up for The Balance’s newsletter for daily insights, analysis, and financial tips, all delivered straight to your inbox every morning.
