If you’re interested in trading derivatives, you’ll likely find yourself wondering about the difference between American vs. European options. No, they’re not regionally exclusive derivatives. You can buy both no matter where you invest, in U.S. markets or overseas. The difference comes in how they’re exercised and what power you have in buying them.
It’s important for investors to understand the style of option they’re trading. Not only does it affect how you’ll exercise the option, it also has bearing on the risk you assume when the time comes to exercise. Knowing your optionable rights gives you foresight into how to capitalize on them. Therefore, here’s an overview of American vs. European options and what makes them different.
An Overview of American Options
The biggest benefit of American options – and the primary reason for buying them – is that they’re exercisable any time before the option expires. This is important because it allows investors to capitalize on a level of certainty. For example, if your call option is 12 days from expiration, you can exercise it at the strike price today.
Options traders tend to prefer American-style options because they offer incredible flexibility. Think about it from a value perspective. If the price of a stock jumped up 20%, you don’t need to wait until the expiration date to exercise American options. It allows investors to better manage risk and capitalize on stock movements.
Also unique to American options is that they settle in stock. This is because you’re optioning individual stocks or ETFs, which have the ability to settle as shares – unlike European options, which involve indexes and settle to cash. The settlement price is equal to the price at last close.
Generally, American options are very accessible. All optionable funds and ETFs have American options; indexes do not. It’s important to remember that American options stop trading at the close of the market on the third Friday of the month they expire.
An Overview of European Options
Unlike American options, which offer the ability to exercise at any time, European options exercise only at expiration. They’re also more affordable for this reason. This combination of low cost and predetermined exercise rights gives investors some level of certainty, which is why many investors prefer them.
The biggest reason to trade European options is because they’re active on most major indexes, such as the S&P 500 (SPX), Russell 2000 (RUT), and the Nasdaq (NDX). With these options, you’re not buying or selling shares – you’re merely buying or selling options on the index. As such, there’s broad activity that makes for a robust options market. When you exercise European options, they settle to cash.
It’s also important to note that the tax treatment of European options tends to be generally more favorable. Investors may be able to count up to 60% of gains as long-term capital gains, whereas American options are taxed as 100% short-term capital gains.
Remember that trading of European options closes one day earlier than it does for American options – the Thursday before the third Friday of the month. Consider this when looking ahead at when contracts settle and expire.
Comparing and Contrasting Options
Investors are likely to encounter both options as they trade, depending on what they’re trading. Keep this quick breakdown in mind as you evaluate options and any risks and rewards attached to them:
- Typically focus on ETFs and individual companies
- Can exercise at any time before the expiration date
- Can buy or sell shares; settles to stock
- Settlement price is the last closing trade price
- Stop trading on the third Friday of the month
- Taxed as 100% short-term capital gains
- Typically focus on major indexes
- Options exercise upon expiration only
- Cannot buy or sell shares; settles to cash
- Settlement price is the opening price of index components
- Stop trading on the Thursday before the third Friday of the month
- Some preferential tax treatment as long-term capital gains
As investors get more comfortable with derivatives, the nuances of different option styles become more apparent. Nevertheless, it’s vital to pay attention to each contract and its exercise rights.
A Third Style of Option: Bermudan Options
While less common than American and European, there are also Bermudan-style options to consider. They’re widely considered an intermediary between American and European options in that they allow exercising on specific days prior to expiration. For example, if the contract expires in August, Bermudan options may allow the investor to exercise every Tuesday in August.
The benefit here is a modicum of flexibility. While they’re not as flexible as American options (exercise at any time), Bermudan options give investors more opportunities to exercise than European options (at expiration). Bermudan options are still considered more exotic options, despite their rising popularity.
The Value of Options Depends on the Style
Generally speaking, investors consider American options to be more valuable than European options. This is because they come with excellent flexibility, including the ability to exercise early and option specific companies or ETFs. However, you’ll pay more for these options contracts.
While considered less valuable, European options are desirable to many investors for other reasons. Namely, because they settle in cash, which is generally beneficial. The tax prospects of European options are also desirable for anyone looking to avoid short-term capital gains.
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At the end of the day, American vs. European options is all about choosing the one that suits your investing thesis and offers the best prospects, while minimizing risk.