#4 European Options are Different
Most options are American-style options and all the rules you already know apply to them. However, some options are European style (no, they do not trade only in Europe), and it’s very important to know the differences if you trade these options.
Most index options are European style: options on the S&P 500, Nasdaq and the Russell 2000, but not on the S&P 100 Index. (Note: These are index options and not ETF options. Thus, the SPDR S&P 500 (NYSE: SPY), PowerShares QQQ Trust (NASDAQ: QQQQ) and iShares Russell 2000 Index (NYSE: IWM) are all American-style options.)
Here are the three main differences:
1. European options cease trading when the market closes Thursday, one day prior to “regular” options expiration day.
2. The settlement price is NOT a real world price. The final “settlement” price — the price that determines which options are in the money, and by how much — is calculated by using trade data from early in the trading day on Friday. However, the number is not made available until much later.Thus, when you observe an index price early Friday morning, do not believe that the settlement price will be anywhere near that price. So be careful. Often this settlement price is significantly higher or lower than traders suspect it will be — and that results in cries of anguish from anyone still holding positions. It’s safest to exit positions in Europeans options no later than Thursday afternoon.
3. European options settle in cash. That means no shares exchange hands. If you are short an option whose settlement price is in the money, the cash value of that option is removed from your account. If you own such options, the cash value is transferred to your account. It’s equivalent to buying or selling the option at its intrinsic value. Once again, that value is unrelated to Thursday night’s closing price.
Learn more about European options.