The investing term European option refers to contracts that give the investor the right to buy or sell an asset at a specific price on a certain date. A European call option provides the investor with the right to purchase an asset, while a put option provides the investor with the right to sell it.
Workings of European Style Options
Like their American Option counterparts, a European option is traded on an exchange, and the contract will specify at least four variables:
Underlying asset – Stock indexes, foreign currencies, and derivatives;
Premium – The price paid when an option is purchased or sold;
Strike price – The price at which the holder of the contract has a right to sell (put option) or buy (call option) the underlying asset;
Maturity date – Also referred to as the expiration date, the option no longer has any value if not exercised on this date.
European Option Types
There are two types of European options, call and put.
European Call Option
A European call option is a financial contract that gives the holder the right, but not the obligation, to buy a specific underlying asset at a predetermined price within a specified period of time from the option seller.
The predetermined price is known as the strike, and the specified period is exactly the expiration date of the option.
The holder of a European call option expects the price of the underlying asset to rise, allowing them to profit by exercising the option and purchasing the asset at a lower price than its market value.
European Put Option
Just like the call option, the European put option is also not obligatory but gives the holder the opportunity to sell the underlying security at the strike price when the contract expires.
Put options, unlike call options, are focused on selling rather than buying, which is why, holders of put options actually expect the price of the underlying asset to decrease.
The put holder benefits when the price of the underlying asset decreases, because it allows them to sell the asset at a higher strike price than its reduced market value.
Let’s say an investor buys a European call option on Apple Inc. (AAPL) stock with a strike price of $150. At the time, AAPL stock trades at $145, but the investor expects it to increase in the coming months. They pay a premium of $5 per share or $500 for a total of 100 shares.
Depending on whether the AAPL stock will increase or decrease by the time their call option expires, the investor will either
Execute their option and buy the stock at a lower-than-market price, if its price increases, or
Lose the money they invested at the premium, if its price decreases.
So in a scenario where upon the call option’s expiration, the AAPL stock trades at $170, the investor will buy 100 shares at a much lower price of $150, earning $20 profit per share. Considering the premium of $5 per share they paid at the onset, they essentially make $15 per share or a total of $1,500 per 100 shares.
However, if the AAPL stock price is below the strike price of $150 at expiration, the investor has no reason to execute their call option, which will expire worthless. In this scenario, the investor will lose their onset investment of $5 per share, or a total of $500.
To avoid losing the entire investment, the only thing the investor can do is try to foresee that the call option will not turn out profitable at expiration, and try to sell it back at the market before it expires worthless.
However, since other investors in the market would also recognize that the option is likely to turn out unprofitable, they may not be willing to buy it at the original premium price. In order to attract buyers and have a chance to offset their initial investment, the investor may need to lower the premium price when attempting to sell the option.
By selling the option at a lower premium, the investor can at least recover a portion of their initial investment and mitigate some of the losses incurred from the premium paid. This strategy allows them to salvage some value from the option rather than losing the entire investment.
European Options Pros and Cons
- Predictable as an investment instrument
- Less expensive than American options
- Carry no early activation risk
- Very simple to evaluate
- Can’t be closed before their expiration
- Limited flexibility in position management
- Typically sold over the counter
- Not as profitable as American options
Closing a European Option Early
Closing a European option early is not possible in the traditional sense. Unlike American options, which can be activated at any time before the expiration date, European options can only be exercised at expiration.
The inability to close a European option early can limit the flexibility of traders and investors, but they can still find an opportunity to manage or exit their positions before expiration by engaging in secondary market trading. By selling their European options, traders can effectively close their European option position and realize any gains or losses associated with it.
The price at which they can sell their options depends on factors such as the remaining time until expiration, market conditions, and the supply and demand dynamics of the specific option contract.
In the above example, where the call option was deemed likely to be non-profitable, the investor had to sell it at a lower price to offset their potential losses. But if the option instead promised to become highly profitable, the investor could opt to sell it earlier for a higher premium, and profit from the difference between the price they paid to buy it and the price they sold it at.
This would allow them to lock in their gains early, before market conditions and fluctuations may potentially erode them. They will also free up capital to invest in a new investment opportunity that may potentially yield higher returns.
American vs European Options
While there are many fundamental similarities between American and European options, there are several important differences, as shown in the table below.
American | European | |
|---|---|---|
Exercisability | Any time before the maturity date | On the maturity date |
Trading market | Exchanges such as the NYSE and NASDAQ | Over-the-counter |
Underlying asset | Stocks, bonds, commodities, and derivatives | Stock indexes, foreign currency |
American options offer investors more flexibility relative to European options since they're able to exercise their rights at any time before maturity. The restrictive nature of European options allows the writer (seller) of the option to know exactly when (and if) the option will be exercised. This limitation lowers the risk of a European option relative to an American option. For this reason, European options will sell at a lower premium compared to their American counterpart.
Can you close a European option early?
Are most options American or European?
Which option is cheaper, American or European?
Additional Terms
- An option contract allows traders to buy (call) or sell (put) an underlying asset at a specific price on or before a designated date and hold the right to scrap the contract. The option holder (the trader who buys the contract) pays a premium to the options writer (the trader who sells the contract). Note that premiums are multiplied by $100, the multiplier for standard US equity options contracts. So an option's premium of $1 is really $100 per contract.
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