European Call and Put Options
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 a right to sell it.
ExplanationLike 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, as well as derivatives.
- Premium: the price paid when an option is purchased or sold.
- Strike Price: identifies 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 expiry date; the option no longer has any value if not exercised on this date.
As is the case with American Options, European-style options also come in two basic forms:
- Call Options: also referred to as calls, this contract gives the holder the right to purchase the asset at the strike price on the maturity date.
- Put Option: also referred to as puts, this contract gives the holder the right to sell the asset at the strike price on the maturity date.
All options provide their holders with certain rights, which are not obligations. For example, a call option gives the holder the right to purchase the asset at the strike price. The holder is not required to complete this transaction.
American versus European Options
While there are many fundamental similarities between American and European options, there are several important differences as shown in the table below:
An American option also offers the buyer more flexibility relative to a European option 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.