European vs. American Style Options. Part II

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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2 Responses to European vs. American Style Options. Part II

  1. Deb 12/30/2014 at 12:56 PM #

    Hi Mark, Thank you for explaining European vs American Options. Very helpful!

    I’m at a point where I’m really working to make sure that I understand Options well and have been practicing credit spreads. So your example on this page has thrown me a bit. In what scenario would you sell a Put spread at 590/580 when the underlying is trading at 560 (lower than the Put spread)?

    Thanks!

    • Mark D Wolfinger 12/30/2014 at 4:16 PM #

      Deb,

      I would NEVER consider selling a 580/590 put spread when the underlying asset is 560. The options are too deep in the money for most traders. Let’s ignore this example and focus on why someone (such as you) would want to sell a put spread:

      1. You have a bullish bias on the underlying stock or index.

      2. You are willing to accept limited profits in exchange for the high probability of earn a profit on the trade.

      3. By selling an out-of-the-money put spread, you earn a profit whenever the options remain pretty far out of the money as time passes — or when the options expire worthless.

      4. Let’s consider selling the 580/590 put spread when the index is worth 720: The profit is yours whenever
      a) the stock rallies and the put spread loses value.

      b) the stock price is relatively unchanged, but time passes, expiration nears, and the spread loses value.

      c) The stock price declines by a small amount, but time passes. You still make money in this scenario and that is the reason for selling OTM put spreads. You can collect a profit even when you are slightly incorrect in your bullish prediction.

      Mark