Differences between American and European Stock Options

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American vs. European Stock Options

American and European stock options have some similar qualities but their differences are equally important. For instance, American-style options owners may exercise their options at any time before the option expires, while European-style options owners may exercise their rights only at expiration or maturity.

Most equity options are American-style options and they are traded mainly in an Exchange. However, many broad-based equity indices, such as the S&P 500, deal in actively traded European-style options.

There are some major differences between American and European options. Here are some of them.

Meaning

  • European Option − European Option lets the option holder the right to buy or sell the Option only at the predetermined future date and price. Such a restriction makes European options less likely to be owned by investors.
  • American Option − American Option has the option to let the owners exercise the Option at any date before the expiry at the pre-set price. The relaxation lets the options be bought and sold exclusively making them popular as well as easily accessible.

Premium

  • European Option − As the option holder of a European Option gets the right to exercise the Option only at the expiration date, the applicable premium on the options is low. The premium being high, the European options are less in demand than their American counterparts.
  • American Option − The American options have the liberty to get exercised at any date prior to the expiration which makes them more in demand, which in turn makes them costly. However, the American options are also more flexible as they can be exercised frequently many times in a given timeframe.

Popularity

  • European Option − European options are traded less and so are less popular.
  • American Option − American options give the authority to exercise them at any time, and hence the majority of the options market contain American options.

Risk

  • European Option − European Options have low risk because their expiration date is fixed and the returns from them can be estimated.
  • American Option − American options have a higher risk because the traders of American options can sell them any time they want. The options have a higher anticipated return and hence the risks associated with them are higher too.

Hedging

  • European Option− It is easy to Formulate a hedging strategy for European options as it is exercised only at a pre-determined date. It makes the European options far safer than American options too
  •  American Option − Formulating a hedging strategy for American options becomes difficult since the option holder ultimately decides the fate of the option contract.

Trading

  • European Option  − Most of the European options are traded majorly over the counter (OTC).
  • American Options − American options are traded majorly over an exchange.
raja
Published on 04-Oct-2021 13:06:44
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