Trader’s Guide: American vs. European Options

What’s the first thing that comes to mind when you see “America” and “Europe” side by side? 

A map? A war from centuries ago? Globalization?

Don’t worry. This isn’t a set-up for an immigration lesson nor a belated geography lesson. 🌎

American vs. European options are terms that describe two styles of exercising options. The words were conceived by American economist Paul Samuelson to differentiate the two methods of trading options. Typically, these two styles use different assets and rely on different trading strategies. 

It’s crucial for every investor looking to succeed in the options market to have a full grasp of these terms. Although pretty similar, their differences are in the minor details, and these details can quickly determine whether you make or lose money in the process.

Options trading can be complicated and a little confusing at first. In fact, even the most sophisticated investors are always looking for information that will improve their knowledge and help them avoid confusion when putting their money on the line.

In this guide, we’ll discuss the basics of options, give you an overview of each style, and then discuss some of the factors that differentiate these two options trading styles. 

So buckle up. Let’s dive in!

The Basics of Options 👨‍🏫

An option refers to a financial instrument that is meant to give an investor the right, but not an obligation to buy (call) or sell (put) an asset at a set price by a fixed future date. In other words, the investor buys a right to purchase or dispose of an asset by the expiry date — but is not required to purchase or sell the asset if they decide against it. 

The pre-set price is known as the strike price, and the option’s value is based on the value of the underlying asset.

A put option gives the investor the right to sell, and a call option provides the investor with the right to buy the underlying instrument. Both have a strike price already determined prior to setting the contract. In addition, both call and put options have a predetermined expiry date by which the contract terms must be exercised. 

Each call option consists of a bullish buyer and a bearish seller, whereas each put option consists of a bearish buyer and a bullish seller.

Exercising the contract terms means the investor is either buying or selling the underlying asset. If the rights are not exercised by the set expiration date, the option expires worthless. The window you have to exercise your option depends on the kind of option you are trading; American vs. European.

American options can be exercised at any time before expiration — this could be in days, weeks, or months depending on the contract. On the other hand, European options can’t be exercised early. They can only be exercised on the expiration date, giving traders less flexibility in options trading.

An Overview of European Options 🇪🇺

As earlier mentioned, European options can only be exercised on their expiration date. 

For example, if Tom buys a European call option today, it means that he has the right to purchase the underlying asset on the predetermined future date and at the predetermined price. The said date and price must be pre-agreed by the counterparties at the time of entering the option contract. 

In the same way, if Tom buys a European put option today, he gains the right to sell the underlying asset at a predetermined future date and price — only when at the expiration date. 

This, and the fact that European options are closely tied to indexes, are the main factors that distinguish European options from American options. 

An investor can speculate with European options but whether or not they make money from these trades depends on where the strike price is in relation to the current market price of the underlying asset at the time the option expires. At this point, it’s essential to know if an option is “in the money”, “out of the money”, or “at the money.”

These three explain an option’s intrinsic value.

• ☑ At the money: An option (both call and put) is at the money when the strike price and market price are equal.
• ☑ In the money: If an option has intrinsic value, then it is in the money. Both American or European call options are said to be in the money when the strike price is below the asset’s market price. A put option is in the money if the strike price is higher than the current market price of the underlying asset.
• ☑ Out of the money: If an option has no intrinsic value, then it is out of money. A call option is out of the money if the strike price is higher than the underlying asset’s market price. A put option is out of the money if the strike price is lower than the underlying asset’s market price.

As an options trader, it is crucial to have a good understanding of these three terms. But this is especially crucial for European options traders because the window for exercising options is fixed. If they misunderstand the market, their options could expire worthless. So a European options investor needs always to be reasonably certain of how the asset’s price will swing.

Example of European Option 📄

To give you a better understanding of how trading a European option works, let’s look at an example:

Janet, who is new in the options market, takes on the advice of her trusted options trading broker and decides to invest in European options. She buys a European call option for 1000 shares in Citigroup with a strike price of $50 and an expiration date three months from the day of purchase. 30 days after the purchase, the stock price jumps to $80/share. Janet gets excited but can’t exercise the option because the expiration date hasn’t been reached.

By the end of the three months, when Janet can exercise the option, the share price is at $55. So Janet still makes a profit by buying the 1000 shares at %50 and selling at $55. But considering that Janet will still need to subtract the upfront premium she made, this scenario is not as profitable as if she had invested in an American option. 

However, the premium price to enter into a European contract is typically lower than the premium for an American contract. So the actual benefit compared to an American option will depend on the timing of selling and the upfront premium for the American option. 

Additionally, Janet can choose to sell the option at any point before the expiration of the three months — instead of waiting for the time to lapse so she can exercise the option. For example, she could have sold the option when the price was $80 and made a profit.

An Overview of American Options 🇺🇸

An American option holder can exercise their right anytime between the execution and expiration dates. This flexibility makes them so popular among retail investors and institutional investors looking to hedge market risk. 

Investors who hold the American option can exercise the option and make maximum profit when the price is at its peak (deep in the money) — at the point where the asset’s price is much higher than the strike price.

American options are more commonly associated with individual stocks and exchange-traded funds (ETFs). Most often, American stock options contracts have an expiration period between three and twelve months.

Typically the American options market is larger and more active than the European options market. But in the same way, it is the most volatile. For example, recent market events have proven that corporate bond vehicles are more stable than equities or ETFs.

Example of an American Option 📃

Following the example above, let’s see what would happen if Janet bought an American option instead of a European. 

So instead of buying 1000 shares in Citigroup, Janet chose to buy an American call option of 1000 shares in Apple Inc at a price of $100 per share and an expiry date of 1 year. The contract states that Janet has the right to purchase stock in Apple Inc for $100 per share. This means that the option’s strike price is $100. 

As the market value of the underlying stock asset changes, so does the value of the option. Two months after Janet purchases the option, the price rises to $135. At this point, Janet decided to exercise her option and buy 1000 shares at $100, therefore paying a total of $100,000. 

Janet then immediately sells the shares at the current market price of $135, making a profit of $35,000 (not factoring in the premium paid.) 

In the same way, if Janet had purchased a put option that gave her the right to sell instead of buy, she would have to exercise her right to sell if the asset decreased in value in order to make a profit.

American vs. European Options – Compared

While the main difference between European and American options lies in when they can be exercised, it is not the only way the two differ. There are many other factors that a trader should consider before choosing which option works best for their ultimate options trading strategy.

But if a trader deals with stocks or ETFs, chances are they may be dealing with American-style options most of the time. On the flip side, if they mainly deal with indexes, then they are likely investing in European-style options.

But wait. Which one is better? 🤔

The answer to this question depends on many factors. For example, although American options offer flexibility and may appear to give way to big profits, there is a cost trade-off, as most times, American-style options charge a higher premium for that convenience. 

It’s also important to note that better returns are not guaranteed for either option, as the returns on investment largely depend on the trajectory of the underlying asset’s price, which is affected by various other external factors such as inflation.

Let’s take the case of Janet, for example. Let’s assume that after Janet purchased the American-style call option, the market went volatile, and the prices of Apple Inc shares took a dip. So fearing that the prices may decline more within the period before the expiry of the contract, Janet chooses to exercise her option just a month in when the price drops to $85.

Soon after, the market picks up again, and a day before the option is set to expire, the price increases to $120 per share. This means that Janet missed a chance to make a profit by exercising the option early. 

Of course, it’s important also to acknowledge that this situation could have been worse if the prices continued to decline. This shows that both option styles carry unique risks — after all, options are typically more speculative than equities. 

That said, here are some of the factors that differentiate the two:

Right to Exercise 📅

Investors acquire the exclusive right to exercise when they buy an option. A holder of an American-style option receives the right to buy or sell the underlying asset anytime before the contract’s expiration date. A holder of a European-style option buys the right to exercise on the expiration date.

Occasionally, it may be beneficial for an option holder to exercise an option before the expiry date — e.g., to collect a dividend. 

But generally, the right to exercise early is not worth much as the ultimate returns on investments depend on other factors such as the direction the underlying share price will take eventually. 

Cash Settlement 💵

Typically, when an American-style option holder chooses to exercise, the assets exchange hands from the seller to the buyer. On the other hand, European options are exercised for cash because their value is dependent on a financial index rather than a stock, ETF, or commodity.

All parties involved benefit when options are settled in cash. For example, an investor need not worry about reconstructing a complex stock portfolio since they do not lose their active holdings if assigned an exercise notice on calls they wrote, such as in covered call writing or the collar strategy.

Additionally, the option owner receives the cash value, while the option seller pays the cash value. This cash value is equivalent to the intrinsic value of the option. If the option is out of the money, it expires worthless and has zero cash value.

Settlement Price 📜

Most investors aren’t a fan of surprises when it comes to their portfolios. But the market can sometimes play a big one on you.

For example, the settlement price of a European-style option often comes as a big surprise to the investor. In many cases, when the market opens on the morning of the 3rd Friday, there may be a significant change in price from the previous night’s closing. This doesn’t always happen, but it happens often enough to make a seemingly low-risk overnight holding a gamble.

Here are possible scenarios that can happen on Thursday afternoon on the day before a European option expiration:

1. An investor can choose to hold on to an almost worthless option hoping for a miracle. If the market shifts higher or lower on Friday morning, they make hundreds or thousands of dollars.
2. If an investor holds an option with considerable value, they are faced with a tough choice. Remember that the option’s settlement price might render it worthless or double its value.

The story is different for American options. While there is no warning with European options, it’s a lot more predictable with American options. An investor can easily see the stock approaching the strike and spend a nickel or two to cover it.

Premiums 💸

When buying an option, the buyer is expected to pay a certain fee to access the right to buy or sell an asset (stocks or other securities) at a pre-set price when or before the contract’s time limit expires.

Often, the intrinsic value and time value influence how much premium an investor will pay. But other factors, such as power limitations, play a part. For example, the ability to exercise the Option at any time before its expiration date increases demand for the American Option, hence increasing its cost.

On the other hand, a European Option premium is cheaper because the holder has the right to exercise the Option only at the expiration date. 

Underlying Assets 📁

Apart from the time factor (the time when an investor can exercise their option), the other main factor that differentiates an American option from a European option is the underlying asset used for each style. 

Although not an absolute rule, individual traded stocks and exchange-traded funds are predominantly American style. In contrast, indices and currency pairs, as well as those traded over-the-counter, are generally European styles. But there might be exceptions to this rule.

In most cases, investors who trade indices and little or no individual traded stocks, or ETFs can be said to be European-style options traders. On the other hand, investors who prefer individual-traded stocks and ETFs but barely put their money on indices can be said to be American-style options traders.

Hedging ⛏

Designing a hedging strategy is difficult when the option contract’s fate lies in the holder’s hands. American options are at the fate of the holder, and they can exercise any time they believe doing so will result in a higher profit. 

Although this flexibility works to the options holder’s advantage, it makes it hard to put together a clear hedging strategy or a way to mitigate risks associated with the trade. 

On the other hand, European-style options give the trader more room to wiggle. Formulating a reliable hedging strategy is relatively easier because the option holder can only exercise the contract only at a set date.

Although hedging can’t entirely remove all the risk associated with the trade, creating a complete net-zero effect is nearly impossible — it can limit the risk to a known amount. However, the effectiveness of an options hedging strategy also depends on how much the premium of the trade is. If the cost of opening a position exceeds the potential profit at the expiration date, it might not be worth it.

Risk Factor ⚠

Because the holder of an American option has the right to exercise that option anytime they believe doing so will result in a profit, American options are associated with a higher level of risk than their counterpart. 

In other words, the holder determines the maturity date of an American option, and they decide to exercise their right whenever they find it fit. This makes this option riskier because their profit or loss can’t be easily predicted. 

On the other hand, because the expiration date is predetermined and the potential loss or gain can be calculated, European Options have a lower level of risk. 

It’s easier for an options trader to design a hedging strategy when they can since they know when they can exercise their right to buy or sell. But when the fate of the option depends on the trader’s personal decision on whether it’s the right time to sell, it makes it riskier and harder to create a hedging strategy. 

Taxes 🏦

The tax charged on an American and a European option may vary depending on the holding period and the complexity of the transactions. For example, whether an option receives short-term or long-term capital gains treatment depends on how long the option was held. 

Generally, taxation on options is different from an extended position (the investor is the buyer) to a short position where the investor is the seller/writer of the option). European-style options tend to qualify for more favorable tax treatment — even when held for less than a year at a time. Under Section 1256 of the U.S. tax code, some index options may be taxed at 60% long-term and 40% short-term capital gain rates.

However, it is important to note that if you invest in more complex options transactions, such as spreads or butterflies, the IRS may see those trades as “straddle” contracts, meaning they may be taxed differently.

American vs. European Options Example 📝

From the above information, you might think selecting an option style is as easy as saying, “I’ll go for this one.”

However, in real life, an investor doesn’t have the liberty to choose between the options. Individual stocks and ETFs typically fall under American-style, while most indexes are European-style. 

Hence if an investor wants to invest in European-style options, they can only do so with indexes. On the other hand, if an investor wants to invest in American-style options, they might need to settle for individual stocks and EFTs. But this is not clear-cut, and there might be a few exceptions.

There is one known strategy used by sophisticated investors to decide which style is most attractive to them. Suppose Karen, an expert trader, wants to trade options based on the S&P 500. In that case, She can buy options on Exchange Traded Funds (ETF) that own all of the index’s component assets, e.g., the SPDR S&P 500 ETF (symbol SPY), or they can invest in S&P 500 Index Options (symbol SPX) on the Chicago Board Options Exchange (CBOE).

Conclusion 🏁

Options come in two main styles, American and European. By now, it should be evident that this has nothing to do with two of the land masses on planet earth. 

Both option styles are pretty similar — they each have strike prices, and expiration dates and are traded on exchanges. But the devil is in the details. It is the little things that influence an option’s investor’s strategy. The factors that differentiate between the two include; the right to exercise, the premium charged, and the risk factors associated with each option, among others.  

But most of all, the main difference lies in the flexibility and the time value that comes with each style. The American option allows you to exercise your option anytime before the expiration date when you think you can make the most profit. In contrast, the European option limits your flexibility, and you can only exercise on the expiration date. 

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