If the option is a call option, the option holder can exercise it to buy shares at the strike price. If it’s a put, they can exercise the option to sell shares. For example, on Jan. 1, if an investor buys a European put option for XYZ with an expiration date of June 30 and a strike price of $50, they will not be able to exercise that option until June 30. If the price of XYZ falls below $50, it would be profitable to buy the shares on the market and exercise the option to sell them for $50, locking in a profit. However, the option holder must wait until June 30 to have the choice of whether to exercise the contract or not. If XYZ rises back above $50 before the expiration date, the investor will likely not exercise it as doing so would guarantee a loss. Even if at some point during the life of the contract exercising the option would have been profitable, the contract holder could not exercise it. This makes European options less complicated than other types of options. Options sellers don’t have to worry about the option getting exercised early. Similarly, the options buyers don’t have to spend time trying to determine the optimal time to exercise the contract. They simply wait until the expiration date to decide.
European Option vs. American Option
American options are the primary alternative to European options. The main difference between the two is when the option holder is able to exercise the contract. This makes American options far more flexible. The holder of the contract can choose to exercise the option as soon as it becomes profitable to do so, meaning they don’t need to worry that the price of the underlying security will change and make it unprofitable to do so when the expiration date arrives. Options sellers must deal with the reduced predictability, as they have to be prepared for the option to be exercised at any time. This lets them charge higher prices when selling options.
Pros and Cons of a European Option
Pros Explained
More predictable for options sellers. Because options holders can only exercise European options on the expiration date, options sellers don’t have to worry about being ready for the options to get exercised early.Options are less expensive to purchase. European options are generally less expensive than American options, giving options buyers the ability to purchase more contracts with the same amount of money.
Cons Explained
Generally sold over the counter. European options are generally not sold over exchanges, meaning they’re less liquid and may take longer to buy and sell than American options.Options buyers have less flexibility. If you hold a European option, you have less flexibility when it comes to exercising the option, meaning you might miss out on an opportunity to profit that you could have capitalized on had you purchased an American option.
What It Means for Individual Investors
When buying and selling options, investors need to pay attention to the type of option they’re trading. European options are more predictable, which can be advantageous for options sellers. But, American options offer the flexibility of early exercise, which could be advantageous for option buyers. However, buyers should keep in mind the restrictions on when they can exercise the contract as it can affect the profit potential of the option.
