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Tejas Gaikwad
In finance, the style or family of an option is a general term denoting the class into which the option falls, usually defined by the dates on which the option may be exercised. The vast majority of options are either European or American (style) options. These options—as well as others where the payoff is calculated similarly—are referred to as "vanilla options". Options where the payoff is calculated differently are categorized as "exotic options". Exotic options can pose challenging problems in valuation and hedging.
An option that can be exercised anytime during its life. American options allow option holders to exercise the option at any time prior to and including its maturity date, thus increasing the value of the option to the holder relative to European options, which can only be exercised at maturity. The majority of exchange-traded options are American.
Since investors have the freedom to exercise their American options at any point during the life of the contract, they are more valuable than European options, which can only be exercised at maturity. Consider this example: If you bought a Ford March Call option in March 2005, expiring in March of 2006, you would have the right to exercise the call option at anytime up until its expiration date. Had the Ford option been a European option, you could only exercise the option at the expiry date, in March 2006. During the year, the share price could have been most optimal for exercise in December of 2005, but you would have to wait to exercise your option until March 2006, where it could be out-of-the-money and virtually worthless.
With an American option, the holder can wait for the most advantageous price to exercise the option. He can exercise the option on any of the trading days up to the expiration date. Due to greater flexibility, American options are more valuable than European-style options, which can only be exercised at maturity.
Example:-
An investor holding an American option that expires on the last Friday in March has the right to exercise that option at any time on or before that date.
Since the option price moves in sync with the underlying asset, the value of the option may rise and fall multiple times over the life of the contract. Most of the options that trade on major exchanges are American options.
Comparing American- and European-Style Options:-
American-style options:- It can be exercised, or acted upon, if your intent is to do what the option gives you the right to do on or before the expiration date. The person holding the option decides.
The advantage of American-style options is that you have more flexibility regarding when and how to exercise them. Most individual stock options and some index options are traded under American-style options exercise rules.
European-style options:- It can be exercised only on the date of expiration. European-style options are traded on many of the cash-based indexes. For example, options based on the S&P 500 and the Dow Jones Industrial indexes are European-style.
The advantage of European-style options is that you are certain about the timeline you have until the option is exercised.
All options can be exercised only once.
An option that can be exercised anytime during its life. American options allow option holders to exercise the option at any time prior to and including its maturity date, thus increasing the value of the option to the holder relative to European options, which can only be exercised at maturity. The majority of exchange-traded options are American.
Since investors have the freedom to exercise their American options at any point during the life of the contract, they are more valuable than European options, which can only be exercised at maturity. Consider this example: If you bought a Ford March Call option in March 2005, expiring in March of 2006, you would have the right to exercise the call option at anytime up until its expiration date. Had the Ford option been a European option, you could only exercise the option at the expiry date, in March 2006. During the year, the share price could have been most optimal for exercise in December of 2005, but you would have to wait to exercise your option until March 2006, where it could be out-of-the-money and virtually worthless.
With an American option, the holder can wait for the most advantageous price to exercise the option. He can exercise the option on any of the trading days up to the expiration date. Due to greater flexibility, American options are more valuable than European-style options, which can only be exercised at maturity.
Example:-
An investor holding an American option that expires on the last Friday in March has the right to exercise that option at any time on or before that date.
Since the option price moves in sync with the underlying asset, the value of the option may rise and fall multiple times over the life of the contract. Most of the options that trade on major exchanges are American options.
Comparing American- and European-Style Options:-
American-style options:- It can be exercised, or acted upon, if your intent is to do what the option gives you the right to do on or before the expiration date. The person holding the option decides.
The advantage of American-style options is that you have more flexibility regarding when and how to exercise them. Most individual stock options and some index options are traded under American-style options exercise rules.
European-style options:- It can be exercised only on the date of expiration. European-style options are traded on many of the cash-based indexes. For example, options based on the S&P 500 and the Dow Jones Industrial indexes are European-style.
The advantage of European-style options is that you are certain about the timeline you have until the option is exercised.
All options can be exercised only once.