European vs American Option

Difference Between European and American Option

A European option can be exercised only at the expiration date, whereas the American Option can be exercised anytime before the expiration date when the option holder desires.  European options are usually traded over the counter (OTC), whereas American Options are traded over a market. Whether an option is a European or an American Option depends on the option holders’ right to exercise the Option at his or her will or at the pre-decided expiration date.

Both these styles have their own pros and cons; it depends on when the option holder wishes to exercises the Option. In this article, we look at their key differences in detail –

What is the European Option?

European Call Option gives the option holder the right to buy a stock at a pre-determined future date and price. The option holder can exercise the Option only when at the expiration date, which has been pre-agreed by the counterparties.

A European Put option gives the option holder the right to sell a stock at a pre-determined future date and price. As mentioned earlier, the option holder can exercise the Option only at the time of the expiration date that was pre-agreed by both the counterparties at the time of entering the option contractOption ContractAn option contract provides the option holder the right to buy or sell the underlying asset on a specific date at a prespecified price. In contrast, the seller or writer of the option has no choice but obligated to deliver or buy the underlying asset if the option is exercised.read more.

Upon comparison between the premium between a European Option and an American Option, the former has a lower premium. The holder of a European Option can sell the Option in the market before the expiration date and make a profit out of the difference between the premiums.

European-Option-vs-American-Option

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What is the American Option?

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 execution date and the expiration date when the price of the assets shoots above 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. In an American Call option, the strike price does not change throughout the contract. If the holder of the Option does not want to exercise the Option, he/she may choose not to exercise the Option since there is no obligation to receive the security or stock. American call options are usually exercised when they are deep in the money, which means the asset’s price is very much higher than the strike price.

An American Put option allows the holder of the Option the right to ask the buyer of the security of the stock anytime between the execution date and the expiration date when the price of the asset falls below the strike price. If the holder of the Option does not want to exercise the Option, he/she may choose not to exercise the Option since there is no obligation to sell the security or stock. An American Put option can be deep in the money when the asset’s price is very much lower than the strike price.

European Option vs. American Option Infographics

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Key Differences

  • European options are traded at a lower volume when compared to American options since they are traded heavily.
  • The premium of a European option is low, and the premium of an American option is high since it allows the liberty to the option holder to exercise the Option at any time before the expiration date.
  • Since an American option can be exercised at any time, the risk is higher, whereas a European option that can only be exercised on a particular future date has less risk.

Comparative Table

Basis of ComparisonEuropean OptionAmerican Option
MeaningEuropean Option gives the option holder the right to exercise the Option only at the pre-agreed future date and price.American Option gives the option holder the right to exercise the Option at any date before the expiration date at the pre-agreed price.
PremiumSince the option holder of a European Option has the right to exercise the Option only at the expiration date, the premium is low.The liberty to exercise the Option at any date prior to the expiration date makes the American Option in more demand, which makes it pricey.
PopularityEuropean options are less popular and hence are traded less.American options are in high demand since it gives the authority to exercise at any time, and hence the majority of the options market are American options.
RiskEuropean Options have a lower risk since the expiration date is fixed, and the loss or profit can be estimated.American options have a higher risk since the option holder of an American option has the right to exercise the Option at any time he or she finds it profitable.
HedgingFormulating a hedging strategy is easier since the option holder can exercise the contract only at a pre-determined date.Formulating a hedging strategy becomes difficult since the option holder decides the fate of the contract.
TradingThey are traded majorly over the counterTraded Majorly Over 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.They are traded majorly over an exchange.

Conclusion

  • European and American Option has a strike price, premium, and expiration date.
  • An American option is pricey, and the premium is higher than a European option since it gives the option holder the right to exercise the contract at any time after entering the contract and before the expiration date.
  • Options can be traded on an exchange or over the counter, depending on the counterparties that are involved in the transaction.
  • American options are most sought after by traders since it gives the trader the right to exit the position at the time, which is highly profitable for him/her.

Recommended Articles

This has been a guide to the European Option vs. American Option. Here we discuss the top differences between European options and American options along with infographics and a comparison table. You may also have a look at the following articles –