European vs. American Style Options

Most options you are American style, but some European style options are very popular with investors. Too many don’t understand how these options differ. Today, we’ll list those differences. Next time I’ll explain why these differences are important.

 

Ability to Exercise

The owner of an American option has the right to exercise – any time before it expires. All options on individual stocks are American style.

Owners of European options can exercise only when expiration arrives. Options
on the major indexes (OEX is an exception) are European. Some examples of actively traded European style options:

  • SPX: Standard & Poor’s 500 Index
  • DJX: Dow Jones
    Industrial Average
  • NDX: NASDAQ 100 Index
  • RUT: Russell 2000 (small cap) Index

 

Settlement Price

American options are easy to understand. When the markets close for trading on the 3rd Friday of the expiration month, the final, or closing, price is the settlement price.  If the option is in the money (that means it has an intrinsic value), it is exercised. The call owner buys shares (and the call seller sells shares), the put
owner sells shares (and the put seller buys shares).

Under the current (recently revised) rules, all in the money options are automatically exercised (although an option owner has the right to notify his broker NOT to exercise such options). Thus:

· If JKLM closes at $49.99 or lower on the 3rd Friday of Nov, all JKLM Nov 50 puts are exercised. The put owner receives $5,000
cash and sells 100 shares of JKLM (for each option). All puts with higher strike prices are exercised.

 

· If JKLM closes at $50.01 or higher on the 3rd Friday of Nov, all JKLM Nov 50 calls are exercised and the call owner pays $5,000 cash and receives 100 shares of JKLM (for each option). All calls with lower strike prices are exercised.

 

European options are different.

Cash Settled

When a European option is exercised, no shares change hands. Instead, owners of options with an intrinsic value receive that intrinsic value in cash. That cash is automatically deposited into the option owner’s account. Similarly, cash is removed from the account of investors who are short (sold, but did not repurchase) the
option.

Example:

The settlement price (see below) of the SPX Jul 1260 call is determined to be 1264.59. Thus, the intrinsic value is 4.59 (difference between strike price and settlement price).

Owners of the SPX Jul 1260 calls receive $459 for each option owned.

Owners of the SPX Jul 1250 calls receive $1459 for each option owned.

Those who are short the SPX Jul 1260 call must pay, and $459 is removed from their accounts.

As a result of cash settlement, owners lose their options (due to
expiration), but are compensated by collecting the intrinsic value of the option, in cash.  Option sellers must pay that intrinsic value to satisfy their obligations under the contract.

Cash settlement is far more convenient than buying and selling shares of stock, making expiration easier for most involved.

 

Calculating the Settlement Price

These indexes also have a final or closing price. But that price is NOT a real-world price determined at any specific time. Instead, the opening price of each component of the index is determined
on the morning of the 3rd Friday of the expiration month. These options do not trade on Friday. The last time they trade is the previous day (Thursday afternoon). Once all stocks in the index have opened for trading on Friday morning, the settlement
price is calculated – as if all stocks in the index were trading at that opening price at the same time. Because all stocks in the index never trade at their opening prices at the same time, the settlement price is not a real price. The official price is not published until hours after the opening (in some cases, not until the end of the day). 

Many times the official settlement price is higher than the day’s official high or lower than the day’s official low, resulting in confusion for traders who do not understand the process. This occurs because the index price is not a real world price. Suppose the market is bullish at the opening. Often, those buyers push stocks to the highest price of the day. When stocks open at different times, some stocks will have already begun to trade at lower prices, and the ‘current’ index price reflects those lower prices. But remember, the settlement price counts only those opening ‘high’ prices. Thus, the settlement price can easily exceed the highest price seen for the index during the day.

To be continued

 

Optionspeak:

Intrinsic value – the amount by which an option is in the money. In other words:

  •  The difference between the price of the stock and the strike price of a call option, when the stock price is higher than the strike price.
  •  The difference between the price of the stock and the strike price of a put option, when the stock price is lower than the strike price.
  •  Many options have zero intrinsic value, and are out of the money.
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