by Wade Hansen | November 11, 2008 6:18 am
Option traders have to deal with many more variable and factors in their trading than stock traders do. And while many investors are acquainted with the basic differences between call options and put options, most investors are unfamiliar with the different option styles available to them.
Options are divided into two broad styles, or categories: American-style options and European-style options.
Actually, these two option styles have more in common than not. Both American- and European-style call and put options share the following standard characteristics:
However, these option styles have one significant difference: when you are able to exercise them. (You can learn more about this difference in the American and European Style Options video.)
American-style options are the options that most individual investors are acquainted with.
You can exercise American-style options any time you want to before expiration.
For instance, if you buy an American-style option on Wal-Mart (WMT) today and it expires in one month, you can exercise it today, tomorrow, the next day or on any other trading day until the option expires.
European-style options are typically less familiar to retail traders because they are much less common.
If you trade options on stocks indexes, like the S&P 500 (SPX), the Nasdaq Index (NASD) or the Russell 2000 Index (RUT), or on currency pairs (forex), like the U.S. dollar versus the euro, or the U.S. dollar versus the Japanese yen, you are most likely trading European-style options.
You can only exercise European-style options at expiration.
So, if you buy a European-style option on the S&P 500 Index today and it expires in one month, you can only exercise that option on the day it expires.
How the Ability to Exercise an Option Affects Price
All other things being equal, the ability to exercise your option at any time, rather than just at expiration, affects the price of the option.
European-style options are typically less expensive than American-style options because the seller of a European-style option is assuming less risk. It is much easier to plan for and hedge your risks as a seller of European-style options because you don’t have to worry about the option buyer exercising the option at any time he or she sees fit.
European-style option sellers know exactly when an option is going to be exercised, if at all. Since European-style option sellers are taking on less risk, they charge a lower risk premium when they sell their options, which lowers the price of the option.
Conversely, American-style options are typically more expensive than European-style options because the seller of an American-style option is assuming more risk. It is much more difficult to plan for and hedge your risks as a seller of American-style options because you have no sure way to know when the option buyer is going to exercise the option because the option buyer can exercise the option at any time he or she sees fit.
Since American-style option sellers are taking on more risk, they charge a higher risk premium when they sell their options, which raises the price of the option.
Watch the following video below to learn more about the difference between American-style and European-style options.
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