What are European Options?
European options can only be exercised on their date of expiration. If an investor wants to exercise their European option contract before its expiration date, they will not be able to do it.
Let us Look at the Concept of European Options in Detail:
- The European option gives its holder the right to buy or sell an underlying asset at a specified strike price on the expiration date.What’s the key difference between European and American options?
- An option contract for an underlying asset or stock is available in a European-style or American option contract. Therefore the investor has little choice.
- Furthermore, most of the indexes use European Options to avoid complexity.
- European index options cease trading at the close of business on the Thursday before the third Friday of the expiration month.
- Due to this lull in trade, the brokers can price the underlying index’s individual assets.
- The Settlement Price of the option can frequently be unexpected due to this approach.
Settlement Price: Reference price for evaluating the value of open derivative contracts upon expiration.
Note 1. Between Thursday’s market closing and Friday’s market opening, stocks or other securities may experience significant fluctuations.
2. Also, the precise settlement price publication on Friday may not happen for several
hours after the market opens.
Types of European Options
- European Call option: An American call option gives the holder the right but not the obligation to buy an underlying security on the date of expiration.
- European Put Option: A European put option allows its holder the right but not the obligation to sell an underlying asset on the date of expiration.
When to Exercise European Options?
- When someone buys an option of a share, its value can increase with the increase in the share’s value and its premium.
- So, if an investor doesn’t want to exercise their contract on the expiration date, in that case, they can sell their option contract before its expiration date at the increased price and can earn a profit, i.e. the net difference between the premium that they paid and the premium they received minus the fees or commission.
Advantages and Disadvantages of European Options:
Advantages:
- European options are less risky and less complex in price due to the limited availability of options for executing the contract.
- European options charge less premium than American options and are less expensive, making them easier to buy.
- The investor gets some certainty due to the predetermined time of expiration.
Disadvantages:
- These options can only be exercised on the expiration date, making them less flexible.
- Risk of Trading Lapse as the trading of European options closes at the end of the business day on Thursday that falls before the third Friday of the expiration month, leading to an unexpected change in the underlying security price.
Important: Trading lapse while trading European options leads to difficulties in determining settlement prices.
Conclusion:
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FAQs: European Options
The primary distinction lies in the exercise timing. The main difference lies in when you can use them. European options can only be used on the day they expire, but American options can be used at any time before they expire.
Yes, you can trade European options on Indian exchanges, providing you with various opportunities to diversify your investment strategy.
The fixed exercise date of European options requires investors to carefully analyze market conditions before making their decision to buy or sell.
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Disclaimer: Investments in the securities market are subject to market risks; read all the related documents carefully before investing.