Last time I discussed the
difference between American and European style option. Today I’ll answer the questions: Why should you care and which style option is
advantageous to trade, assuming you adopt my recommended
strategies.
- European options
may not be exercised prior to expiration. If the owner of a Europeans style option wants to remove the position
from a portfolio, the option must be sold. Advantage: European.
When
you are assigned an exercise notice on an option you sold short, it’s not a significant
event when the settlement occurs in shares of stock. Why? Because the stock
position that results from the assignment leaves your portfolio essentially the
same as it was (measuring risk and reward) before the assignment. But when the option is cash-settled
receiving an assignment notice earlier than you expected can produce a big
problem with increased risk. Here’s why:
If,
for example, you sold the OEX July 580/590 put spread (sold the 590s; bought
the 580s), you have a position that loses money when OEX drops and makes money
when OEX rallies. Assume that the market
is very bearish one afternoon, and OEX declines to 560. Also assume that bullish news is announced one
minute before the closing bell and the markets start to move higher. Responding to the news, OEX moves higher and closes
at 563.
Here’s
what happens to you if you are assigned an exercise notice on the Jul 590
puts.
a. You first learn that
you have been assigned early next morning, before the market opens for
trading. That means that you repurchased those options yesterday but were unaware of that until the assignment notice arrived.
b. Remember, these
options are cash-settled and no shares exchange hands.
c. When assigned an
exercise notice on a cash-settled option, you are obligated to buy the 590 put
at its intrinsic value as of the previous
day’s close. In this example, that’s $27 (590 strike price minus 563 OEX
price = 27). That’s $2,700 per
option.
d. Your position is
now naked long the 580 puts. Not a
problem? Remember the market turned very
bullish at the close of trading – and that’s the reason the owner of the put
options exercised them.
e. Sure enough, the
futures are significantly higher this morning, and when the market opens, your
580 puts are trading at 16. You have two
choices.
i. Sell those puts
at 16. If you do that, you effectively
pay $1,100 for a spread that is never worth more than
$1,000. Not a happy situation.
ii. Hold the puts and
hope the market falls. But, that’s a
risky play and you can lose all or most of the remaining value (currently
$1,600) of each option.
This
cannot happen to you when the options are European style.
- European options
are all cash settled. Depending on the
strategies you adopt, it’s usually more convenient when options settle in cash. Minor advantage: European.
- Settlement price.
American options settle at the closing
price of the underlying asset at the close of business on the 3rd
Friday of the month. That’s simple and
straightforward. But, the settlement
price of European options is determined by the price of each component of the
index – when it opens for trading the morning of the 3rd
Friday. As discussed,
you never know where the market will open, and options that appeared to be
safely out of the money and apparently were going to expire worthless suddenly
become worth hundreds, even thousands, of dollars apiece. That’s a very large risk for option sellers,
and in my opinion, if you are short any European style options, it’s better to cover
them (buy them back) sometime before the market closes on Thursday, and not
gamble by waiting for the market to open on Friday to learn your fate. Advantage: American.
If
you take the precaution of not allowing yourself to be exposed to a surprise
Friday opening by closing positions on
Thursday, then European options have significant advantages over American.
If
you understand that trading individual stocks is riskier (but the rewards tend
to be greater) than trading indexes, then you may prefer index trading – and that
comes with the added advantage of European style options.
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