European Options
When an investor has the right, but not the obligation, to buy or sell a stock at an agreed-upon price and date, it is known as a stock option. There are two types of options: the put option which is a bet that a stock will fall, or the call option which is a bet that the price of a stock will rise.
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What are European Options?
European options show the timeframe when holders of an options contract may exercise their rights related to the contract. These rights for the option holder include buying and selling of the underlying asset at the contract price that was specified earlier, also known as the strike price. With European options, the holder only gets to exercise their rights on the day of expiration. With other versions of options contracts concerned, European options come at an upfront cost known as the premium. These options normally trade over the counter market (OTC), while American options trade on standardized exchanges.
How does the European option work?
For example, Jacob an investor purchases a European call option on March 1st which expires on the third Friday in March. While in the second week of March, the value of the underlying asset goes above the strike price. The holder of the European option fails to take advantage to earn monetary advantage by locking in a profit because the only date he can exercise this option is on its expiration date.
On the other hand, American options can be exercised at any time from the date of purchase until the expiration date. The holder of an American option gets to decide the best point and value of his option, even if its maturity has not been reached. Such an option is then sold before maturity.
Whereas, the owner of a European option is forced to wait until the maturity of the contract. In the example above, Jacob may find that the European option has less worth at maturity than when he purchased it. Only if he had held an American option, he might have been able to make some profit earlier in the life of the option.
Advantages:
- The predetermined time of expiration of the contract gives the investor some certainty.
- European options are less expensive than American options. Due to the added flexibility of exercising the American option at any time, the upfront cost tends to be higher than European options.
- This seems to be less risky, and the less complex pricing structure is due to the availability of limited options of contract execution.
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Disadvantages:
- European options though less risky than American options have certain risks attached to them. They are subject to other types of unique risks. A different and well-thought approach has to be adopted in order to avoid such risks.
- Trading lapse is one such risk. Trading of European options closes at the end of the business day on a Thursday that falls before the third Friday of the expiration month, which may lead to an unexpected change in the price of the underlying.
- The settlement price can sometimes be a little tricky to determine due to the trading lapse risk.
- Investors don’t get the chance to exercise their options to take advantage of a favorable price move.
- The majority of European options are traded over the counter which doesn’t leave much room for regulations, adding another degree of risk to it.
- The BSM model used for pricing may not be the most accurate model due to some unrealistic assumptions involved in the calculation.
Final Thoughts:
European options generally trade at a discount to their American counterparts because of only a single opportunity to exercise the option. If the holder of the European option doesn’t wish to wait until the expiration date, the only way of closing the option is by selling it. These options usually trade over the counter and are very rarely seen on the major exchanges. European options, tend to trade on index funds and can prove to be valuable financial assets for stock traders.
Author: Mahek Medh
About the Author: Currently, I am in my second-year bachelor’s program and over the period of time I have realized that I enjoy learning about numbers and money, and I find topics of Finance to very interesting thus this is the domain and space where I wish to etch my long term career.
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