American vs European Options
Options are financial derivatives that obtain their value from an underlying asset. Options give the buyer of the option the right but not the obligation to buy or sell a financial asset at an agreed on price on a predetermined date. There are two different types of options that include American options and European options. It must be noted that the option names have nothing to do with America or Europe. These options are similar in many ways, but have some differences with regards to how they can be exercised. The article below provides a clear explanation of American option and European option, their features, how they work, what they are used for, and explains the differences between these two types of options.
American Options
American options can be exercised at any date before the date of expiry. There are a number of methods which can be used to value an American option which include the binomial options method, Monte Carlo method, Whaley method, etc. American options are generally not exercised before their expiry date as they are worth more the longer they are held. A good way to decide whether to exercise the option or hold it till expiry is to observe whether any dividends are being paid on the underlying asset from the time of purchase to the expiry date. If dividends are not paid it can be assumed that the option has a higher intrinsic value, and the option is generally held till expiry.
Advantages of holding American options are that the investor can exercise the option at any time they chose; this provides the investor with a larger degree of flexibility and control. This privilege means that American options are generally more costly than European style options for the same stock.
European Options
European options cannot be exercised early and can only be exercised at the time of expiry, and not any time earlier. European options are generally valued using the Black model or Black-Scholes formula. European options provide the investor with less flexibility and these options usually cost less than American options for the same stock. Financial index options such as Nasdaq 100 are European style options.
The main disadvantage associated with European style options is that they do not allow the investor to decide when the option will be exercised. This means that even if the investor wants to pull out of an investment that is assumed to be losing its value this is not possible with European option and the investor will have no option other than to hold till expiry.
What is the difference between American and European Options?
Options are financial derivatives that derive their value from an underlying asset. Options offer the buyer a right and not an obligation to call (buy a security) or put (sell a security) at an agreed on strike price on a specific date known as the exercise date. The options come in two styles that are known as American options and European options. The buyer of an American option has the right to exercise it at any time before the expiry date; therefore, these options are usually more expensive than the European options for the same stock that does not offer this privilege. Most exchange traded stock options are American style options, but financial index options are traded in both American and European styles; the S&P 100 index options are American options and Nasdaq 100 Index options are European options.
Summary:
American Options vs European Options
• Options are financial derivatives that derive their value from an underlying asset.
• American options can be exercised at any time before expiry which provides the investor with a larger degree of flexibility and control.
• European options cannot be exercised early and can only be exercised at the time of expiry, and not any time earlier.
• American options are usually more expensive than the European options for the same stock.