American-Style Option

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American-style option

American-style option

American Option

American-style option.

A listed option that you can exercise at any point between the day you purchase it and its expiration date is called an American-style option. All equity options are American style, no matter where the exchange on which they trade is located.

In contrast, you can exercise European-style options only on the last trading day before the expiration date, not before. Index options listed on various US exchanges may be either American- or European-style options.

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American and European Options

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  • Quantitative Finance >

This is an introductory page in Options. If you are unfamiliar with any of the terms, you can refer to the Options Glossary.

The style of an option helps us to identify properties that are common to many different types of options. European options may only be exercised on expiration, while American options may be exercises on any trading day up to expiry. Other options which have different payoffs / exercise rules are known as exotic options.

Contents

European Options

A European option can only be exercised on the expiration date of the option. As such, an existing position can only be closed by trading out of it in the market.
Most over-the-counter options are European. Options on the indexes are generally European.

The stock is trading at $20. The European call on the $10 strike expiring in 1 months is actively trading at $9. What trade do you want to execute?

Note that European index options stop trading one-day earlier (IE at the close of business on the Thursday preceding the third Friday). Based on the opening price for each stock in the index, the exact value of the future is determined, and all of the options settle into the cash value of the option’s intrinsic value. Note that this calculated price need not be in line with the price of the future, due to uncertainty / imbalances in the opening price of individual stocks

European options are typically valued using the Black-Scholes model which offers a simple equation with a closed-form solution. This has become the standard in the financial community.

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When would you early exercise an European option?

American Options

An American option can be exercised on any trading day up to the expiration date of the option.

All (most) stock and equity options traded on the exchanges are American options. Most future options are American, though commodity options could also be European.

The most common choice of models for an Americal option are Binomial tree and Monte Carlo. There is no general formula to value an American option.

Early Exercise of American Options

Early exercise refers to exercising an (American) option prior to its expiration date. Early exercise of call options allows the investor to purchase the underlying security at the strike price today, while early exercise of put options allow the investor to sell the underlying security at the strike price today.

American options are rarely early exercised for the following reasons:

  1. American options have a non-negative time value, which is lost when exercised.
  2. It is often less costly to trade out of the position (pay bid-ask spread + trading fees) then to exercise the option (commissions charged by the broker).
  3. For call options, it costs more to exercise the option today and buy the stock for the strike price of K, then it would to exercise it in the future.

Thus, based on the above, there are several guidelines that should influence your decision of early exercise:

The time value should be compensated for.
For calls: The (extrinsic) value of the put + cost of financing the strike When you have made money on it When the dividend payment outweighs the sum of the insurance and saved interest value When the call is ITM Never When the put on the same strike/expiry has delta 0

When would you want to early exercise an American call?

For option sellers / those trading multi-leg strategies, the possibility of early exercise could affect the overall position that you have. The above guidelines will offer you a warning of when your short positions may be early exercised, and you can trade accordingly. In other cases, it is most likely the the option buyer made a mistake and you would likely have profited from it (assuming that the future does not move significantly).

What is the difference between American and European option?

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American and European options are two different types of option found in the stock market, Indian stock market only has European Options.

Following is the difference between the two:

All optionable stocks and ETFs have American-style options Major broad-based indices, including the S&P 500, have very actively traded European-style options.

Indian stock market only has European Options

2. The Right To Exercise

Owners of American-style options may exercise at any time before the option expires while owners of European style options may exercise only at expiration.

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