Finance

American vs European options

American options vs European options

An option is a right, but not an obligation to buy(sell) an option that is derived from the underlying asset (Stock, Commodities, Currencies, Indices) at a certain price and a certain date

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Types Of options:

Call option: A Call option gives the option holder the right to buy an asset at a certain price on a certain date.

Put option: A Put option gives the option holder the right to sell an asset at a certain price on a certain date.

The price in the option contract is known as the Strike Price(K) or Exercise date and the date in the option contract is known as the Expiration date or Exercise date.

American vs European options

The term American and European of the option contract does not belong to the country origin and nothing to do with geographical location. The overview of American vs European options is mentioned below.

American Style Option:

An American-style option can be exercised any time during the life of the option or at the maturity date. It is denoted by Capital ‘C’. American Style options are more costly or expensive than the European Style option. The reason behind this is the Time value Decay of the option. Most of the stock’s options are American Style options.

  • An American Call option allows the holder of the Option the right to ask for the delivery of the security or stock anytime between the exercise date and the expiration date when the price of the stock moving above the strike price
  • An American Put option holder has the right to ask the buyer about the security of the stock anytime between the exercise date and the expiration date when the price of the asset falls below the strike price.

European Style Option:

A European style option can be exercised any time during the life of the option or at the maturity date and never before the expiry day. It is denoted by the small letter ‘c’. European Style options are less valuable than the American Style option. While most of the Index options are European Style options.

  • The European call holders give the right to buy the stock at a pre-fixed price and on a specific future date.
  • The European put holders give the right to sell the stock at a pre-fixed price and on a specific future date.

The terminology of American Style Option vs European Style Option

  • CE: Call European
  • CA: Call American
  • PE: Put European
  • PA: Put American

How they are traded?:

Most of the American style options are traded on the stock exchanges and the European Style options are traded on the Over-the-Counter Market.

Six Factors that can affect the options price for both the American and European options:

They are four types of Options Positions and payoff:

1. A long position in a call option

2. A long position in a put option

3. A short position in a call option

4. A short position in a put option

Payoffs from positions Payoffs do not deduct premiums. It is the strike price and is the final price of the underlying asset, the payoffs are

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Upper Bound:

An American or European call option gives the option holder the right to buy one share of stock for a certain Strike(exercise) price. No matter what happens, the option can never be worth more than the stock (c or C ≤ S0) An American put option gives the option holder the right to sell one share of stock for K but how low the stock price becomes, the option can never be worth more than K. (P≤K ) While the European put options, at expiry, the option cannot be worth more than K. It follows that it cannot be worth more than the present value of K today (p≤K *e^-rt ).

Lower Bound:

A lower bound for the price of a European call option on a non-dividend-paying stock is the stock price minus discounted strike price. This is the price the Black-Scholes gives if the volatility input is equal to zero. The option can expire worthlessly, its value cannot negative, so the lower bound is c ≥ (max S0 -K*e^-rt, 0). • For a European put option on a non-dividend-paying stock, a lower bound is a maximum of zero or discounted strike price minus the stock price p ≥max (K*e^-r t – S0, 0).

 

Risk Involved:

European options are lower the risk because we knew that the expiration day or maturity date is fixed and we can predict the probability of profit and loss of the future option.

American options are higher the risk because the option can exercise any time during the life of the option when the options trader gets the profit he can exercise any time, so the option premium is higher in the value and a risky option.

Conclusion

American call options are exercised early when they deep in the money because the Stock price is higher than the strike price.  An American Put option can be deep in the money when the stock price is very much lower than the strike price. The European option holder can sell the option before the maturity date and gains profit on differences with the premium.

Author: John Earla

About Author: Currently pursuing Financial Risk Management from GARP(US) and completed Graduation in B.Com computers. John is interested in finance and Risk Analysis.

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