Financial derivatives

Explain the Options and discuss the difference between American and European options

Options are financial derivatives that derive their value from an underlying asset. Options give the option buyer the right, but not the obligation, to buy or sell a financial asset at an agreed price on a predetermined date. There are two different types of options which include American options and European options. Note that the option names have nothing to do with America or Europe. These options are similar in many ways, but have some differences in how they can be exercised. The following article clearly explains American options and European options, their characteristics, how they work, what they are for and explains the differences between these two types of options.

American Options

can be exercised on any date prior to the expiration date. There are several methods that can be used to price an American option, including the binomial option method, the Monte Carlo method, the Whaley method, etc. American options are generally not exercised before the expiration date because the more they are worth, the longer. faint. A good way to decide whether to exercise or hold the option to expiration is to look at whether dividends are paid on the underlying asset between the time of purchase and the expiration date. If dividends are not paid, the option can be assumed to have a higher intrinsic value, and the option is generally held until expiration.

The advantages of holding US options are that the investor can exercise the option at any time. This provides the investor with a greater degree of flexibility and control. This privilege means that American options are generally more expensive than European-style options for the same title.

European Options

cannot be exercised early and can only be exercised at expiration, not before. European options are generally priced using the Black model or the Black-Scholes formula. European options offer less flexibility to the investor and these options generally cost less than US options on the same stock. Financial index options like the Nasdaq 100 are European-style options.

The main drawback associated with European-style options is that they do not allow the investor to decide when to exercise the option. This means that even if the investor wants to withdraw from an investment that should lose value, this is not possible with the European option and the investor will have no choice but to hold until expiration.

What is the difference between American and European options?

Options are financial derivatives that derive their value from an underlying asset. Options give the buyer the right, not the obligation, to call (buy a share) or put (sell a share) at an agreed-upon strike price on a specific date called the exercise date. Options come in two styles known as American options and European options. The buyer of an American option has the right to exercise at any time before the expiration date; therefore, these options are generally more expensive than equally safe European options that do not offer this privilege. Most exchange-traded options are American-style options, but financial index options are traded in both American and European styles; options on the S&P 100 index are American options and options on the Nasdaq 100 index are European options.

Summary:

US Options vs. European Options

• Options are financial derivatives that derive their value from an underlying asset.

• US options can be exercised at any time prior to expiration, giving the investor a greater degree of flexibility and control.

• European options cannot be exercised early and can only be exercised at expiration and not before.

• US options are typically more expensive than European options for the same stock.

Step-by-step explanation

The American and European options have similar features but the differences are significant. For example, US-style option holders can exercise at any time before the option expires.¹

European-type options, on the other hand, can be exercised at expiration.

Although stocks are American-style options, broad-based indices, including the S&P 500, have been actively traded in Europe

Key Points

• Most stocks and exchange-traded funds have American-style options while equity indices, including the S&P 500, have European-style options.?
• European index options stop trading one day earlier, at the close of business on the Thursday preceding the third Friday of the expiration month.
• The settlement price is the official closing price for the expiration period, establishing which options are in the money and subject to auto-exercise.

American options

are contracts that derive their value from an underlying asset or investment . Options give the owner the right to buy or sell the underlying asset (such as a stock), at a fixed price (called the price), no later than a specified expiration date in the future. The call option gives the owner the right to buy a share, for example, while an option gives the owner the right to sell the share. The initial cost (called premium) is what the investor pays to purchase the option.

Stock options are typically for a single stock, while index options are based on a basket of stocks that can represent the entire stock market or a portion of the market, such as a specific sector. A stock option can be exercised before its expiration date (if it is American-type), while an index option can only be exercised at expiration (if it is European-type). However, investors can close an option position by selling it before expiration, including European-style options, although there may be a profit or loss between the premiums paid and received.

All stock options and exchange-traded funds (ETFs) have US-style options, while only a few broad indices have US-style options. US index options cease trading at the close of business on the third Friday of the expiration month, with a few exceptions.¹For example, some options are quarterly, trading until the last trading day of the calendar quarter, while weekly options stop trading on the Wednesday or Friday of the calendar quarter. specified week.

clearance price is the official closing price for the expiration period, which determines which options are in-the-money and subject to self-exercise. Any option that has a penny or more in the money on the expiration date is automatically exercised unless the option owner specifically tells their broker not to exercise it. The settlement price of the underlying asset (stock, ETF or index) with US-style options is the normal closing price or the last trade before the market closes on the third Friday. Transactions outside of business hours are not taken into account in determining the settlement price.

With American-style options, there are rarely any surprises. If the stock is trading at $40.12 just minutes before the closing bell , you can expect 40 puts to expire worthless and 40 calls to be in the money. If you are short on call 40 and do not want to receive a strike alert, you can buy back those calls. The settlement price may change and 40 calls may be sold out, but the value is unlikely to change significantly in the last few minutes.

European Options

Options on European indices stop trading one day earlier, when trading closes on the Thursday before the third Friday of the expiration month.

It is not so easy to identify the closing price of European-style options. In fact, the settlement price is only published a few hours after the market opens. The European settlement price is calculated as follows:

• is determined on the third Friday of the month opening price Individual stocks open at different times, with some of these opening prices available as early as 9:30 am ET while others are determined minutes later. 
• The price of the underlying index is calculated as if all shares were trading simultaneously at their respective opening prices. This is not a true price because you cannot look at the published index and assume the settlement price is close to value.

Exercising rights

When you have an option, you control the right to exercise. Sometimes it can be useful to exercise an option before it expires, for example to collect a dividend, but it is rarely important. Dividends are cash payments made by companies to shareholders as a reward for investors. When you sell a US-style option, you sell the option without holding it and receive a strike notice before expiration and short the stock.

The only time early redemption carries significant risk is with US-style cash-settled index options, suggesting that the easiest way to avoid early exercise risk is to avoid US options. If you receive an assignment notice, you must repurchase that option at the previous night's intrinsic value, exposing you to serious risk if the market makes a significant move.

Cash Settlement

It is beneficial for all parties when options are settled in cash:

• no shares are traded manually.
• You don't have to worry about rebuilding a complex stock portfolio because you don't lose active positions if you receive a strike warning on call options you've written, such as in the case of writing covered call options or a tunnel strategy.
• The option owner receives the cash value and the option writer pays the cash value of the option. This redemption value is equal to the intrinsic value. If the option is out of the money, it expires worthless and has no cash value.

These cash-settled options are almost always European-style and are only assigned at expiration, so the option's cash value is determined by the settlement price.

Settlement

The settlement price is often a surprise with European-style options because when the market opens for trading on the third Friday morning, there may be a change in price from the previous night's close of trading. It doesn't always happen, but it happens often enough to turn the seemingly low-risk strategy of holding position overnight into a gamble.

This is the scenario facing European options traders on Thursday afternoon, the day before expiration:

• If the option is almost worthless, hoping for a miracle is not a bad idea. Owners of low-priced options worth a few cents or less made hundreds or thousands of dollars when the market rose or fell Friday morning. However, these options expire worthless most of the time.
• If you have an option that has significant value, you need to make a decision. The settlement price could cause the option to lose value or double in value. Do you want to roll the dice? This is a risk-based decision that individual investors must make on their own.

When you sell the option, you face a different challenge:

• When you're short an out-of-the-money option, hedging is a smart move. With American-style options, you'll see the headline come close to striking and you can spend a dime or two to cover it. But with the European options, there is no warning. Any out-of-the-money option can move 10 or 20 points in the money, costing between $1,000 and $2,000 per contract when forced to pay the settlement price. It's not worth the risk.