American vs European Style Options

Despite their names, American and European style options don’t have anything to do with regions or locations. They are simply different types of option exercise.

American style options can be exercised at any time before the option expiration date while European style options can only be exercised at the option expiration date.

You’ll find that the majority of options for equity stock are American style while the majority of options for futures are European style.

Why does this matter and what difference does this make?

Whether an option is of an American style or of a Europrean style affects how it behaves over its lifespan and how it’s priced.

Generally speaking, American style options tend to have slightly higher premiums than European style options because there is more flexibility for the option contract to be exercised (for the holder) and a higher risk to be exercised against (for the seller).

For example, if you sell to open options in the European style, you don’t have to worry about being exercised against, or in other words, being assigned shares of the underlying asset until the expiration date comes along. This may matter if being assigned shares poses a detriment to your position and strategy. For a European style option, you can easily avoid assignment by closing your position and getting rid of the option well before the expiration date. American style options, on the other hand, can be exercised anytime so there is always a risk that you might be assigned shares.

Most important to note, European style options on index futures stop trading on the day before the expiration date. For monthly options that expire on the 3rd Friday of the month, a European style option on index futures will stop trading one day before that, which is the 3rd Thursday of the month. To avoid such potential surprises and issues, it is most likely best to close out of any such positions well before the expiration date to minimize risk. This generally holds true for all options.

Cash Settlement

Another detail about European style options is that they tend to be cash settled options. This then leads to the question, what is a cash settled option?

A cash settled option is one that does not require settling in the underlying asset. This means that if the option is exercised, only cash in the amount of the underlying asset is exchanged between the option writer (the person who sold an option to open a position) and the option owner (the person who bought an option to open a position).

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