European Option

What is the European Option?

A European option can be defined as a type of options contract (call or put option) that restricts its execution until the expiration date. In a layman’s terms, after an investor has purchased a European option, even if the price of the underlying security moves in a favorable direction, i.e., increase in the price of the stock for call options and decrease in the price of the stock for put options, the investor cannot take advantage by exercising the option early.

Types of European Option

Below are the two types of European options.

#1 – European Call Option

Holders of such contracts have the ability to buy a predetermined quantity of the underlying at the expiration date at a predetermined price, also known as the strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more. The investor is bullish on the market.

#2 – European Put Option

Investors can sell a predetermined quantity of the underlying at the expiration date at the strike price. Investor opinion is bearishBearishBearish market refers to an opinion where the stock market is likely to go down or correct shortly. It is predicted in consideration of events that are happening or are bound to happen which would drag down the prices of the stocks in the market.read more.

The formula of European Option

Black Scholes Merton Model or BSM model is more suited for the pricing of European options since one of the assumptions that this model rests on is that the options aren’t exercised early.

European-Option

Pricing a European Call Option Formula

Price Call = P0N(d1) – Xe-rtN(d2)

Where,

  • d1 = [ln(P0/X) + (r+v2/2)t]/v √t  and  d2 = d1 – v √t
  • P0= Price of the underlying security
  • X= Strike price
  • N= standard normal cumulative distribution function
  • r = risk-free rate
  • v= volatility
  • t= time until expiry

Pricing a European Put Option Formula

Price Put = Xe-rt *(1-N(d2)) – P0*(1-N(d1))

Where d1 and d2 can be calculated in the same way as in the pricing of call option explained above.

Practical Example of European Option

Stock XYZ is trading for $60. The strike price is $60. Volatility is 10%, and the risk-free rate is 5%.

You can download this European Option Excel Template here – European Option Excel Template

Calculate the value of both a 1-year call and put options are written on it using the BSM model.

  • Price of the Underlying Security (P0): $60
  • Strike Price (X): $60
  • Volatility (V): 10%
  • Risk-Free Rate (r): 5%
  • Time Until Expiry: 1

Calculation of d1

European options example 1-1
  • d1 = [ln(P0/X) + (r+v2/2)t]/v √t
  • = LN(60/60)+(5+10^2/2*1)/(10*SQRT(1))
  • =0.55

Calculation of d2

European options example 1-2
  • d2 = d1 – v √t 
  • = 0.55-60*SQRT(1)
  • = 0.45

We got the following values from normalization table

Example 1-3

So the calculation of the price of the call option using the above table –

Example 1-4

Price of call= $4.08

calculation of the price of the put option using the above table –

Example 1-5

Price of put= $1.16

Prices are also calculated in the solved example excel sheet.

Before we move forward to its advantages and disadvantages, let’s talk a little about the upper and lower price bounds for European call and put options.

  • Lowest bound for a Call =0 (Option price can never fall below zero)
  • Highest bound for a Call= P0 (Current value of the underlying)
  • Lowest bound for a Put = 0
  • Highest bound for a Put = Xe-rt (Present value of strike price)

How European Options Differs from American Options?

European Options differ from American options in the sense that American option holders have the liberty of exercising the option anytime, be it on or before the expiration date. Investors of such options can, however, choose to sell their holdings in the market before the expiration date approaches. Under such circumstances, profit is essentially the difference between the premium earned and the premium paid.

Also, European and American options are mutually exclusiveMutually ExclusiveMutually exclusive refers to those statistical events which cannot take place at the same time. Thus, these events are entirely independent of one another, i.e., one event's outcome has no impact on the other event's result.read more in the market. Both aren’t offered at the same time, so investors don’t have a choice.

Both these options basically differ on three grounds:

European OptionsAmerican Options
Can be exercised only at its expiration date.Can be exercised anytime during the life of the option.
Traded over the counter.Traded only on exchanges.
Generally, have a lower upfront cost, i.e., premium.Have higher premiums.
Can have stocks and foreign currencies as the underlying.Can have stocks, bondsBondsA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually.read more, commodities, and derivativesDerivativesDerivatives in finance are financial instruments that derive their value from the value of the underlying asset. The underlying asset can be bonds, stocks, currency, commodities, etc. The four types of derivatives are - Option contracts, Future derivatives contracts, Swaps, Forward derivative contracts. read more as the underlying security.

Advantages

  1. There is a predetermined time of expiration of the contract that gives the investor some certainty.
  2. These options are less expensive than American options. Due to the added flexibility of any time exercise in American options, the upfront cost tends to be higher than European options.
  3. This tends to be less risky, and the pricing complexity is also less due to the availability of limited options of contract execution.

Disadvantages

  1. European options though less risky than the American options, aren’t devoid of risks. They can be subject to other types of unique risks. A meticulous approach has to be adopted in order to avoid such risks.
  2. One such risk is the trading lapse 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. This can lead to an unexpected change in the price of the underlying.
  3. The settlement price might be a little tricky to determine due to the trading lapse risk.
  4. Investors don’t have the ability to exercise their options for taking advantage of a favorable price move.
  5. The majority of such options are traded over the counterOver The CounterOver the counter (OTC) is the process of stock trading for the companies that don't hold a place on formal exchange listings. The broker-dealer network facilitates such decentralized trading of derivatives, equity and debt instruments.read more, so there isn’t much regulation involved, adding another degree of risk to it.
  6. The BSM model used for pricing might not be the most accurate model due to some unreal assumptions involved in the calculation.

Limitation

  1. European options aren’t much accessible due to it being traded over the counter.
  2. The pricing model makes certain assumptions of dividendDividendDividend is that portion of profit which is distributed to the shareholders of the company as the reward for their investment in the company and its distribution amount is decided by the board of the company and thereafter approved by the shareholders of the company.read more, volatility, and risk-free rate being constant during the entire duration, which is unreal, and hence prices might be different from the real world.

Conclusion

The naming of European and American options has nothing to do with the respective geographical locations. It simply gives an idea of when an option can be exercised. A majority of options traded in the US are known to be European options. Due to the difference in the features of the two options, investor expectations also vary. Like, an American option holder would expect the prices to move favorably before the expiration date arrives. However, the same isn’t true for European option holders who hope that such changes happen only at expiration.

Recommended Articles

This has been a guide to what is European Option and its Definition. Here we discuss the formula to calculate the Price of the European Call and Put option along with practical examples, advantages, and disadvantages. You can learn more about accounting from the following articles –

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