Today, I’m going to discuss the major difference between the two styles of options, American and European. There are various differences between the two types of options that you need to know about.
Not knowing the difference between the two options styles can cause unnecessary loss to your portfolio which is something that can be easily avoided by understanding a few details about how option expiration and exercise work.
Most U.S. exchange listed stocks and ETF’s are American style options. While the great majority of stock indexes options are European style options. The only exception to that is the OEX or the SP 100 index, which happens to be an American style option.
American style options are settled with shares while European options are settled in dollars, this is a major difference between the two and something you need to keep in mind. The only exception to this is once again the OEX, which cannot be settled in shares, because it's an index that's made of numerous stocks.
Another major difference between American and European exercise is timing. American options can be exercised by the buyer any time before the exercise cut off date and time. The last opportunity to exercise an American style option contract by the option holder (buyer,) is typically at the closing or one hour after the closing on the last trading day. For regular option, it would be the third Friday of each month and for weekly options traders, it would be the specific Friday of each week.
The mechanics of exercise are a bit different for European options and this is something I want to make sure that you understand. European style options cease trading one day earlier than American style options. While American style options cease trading on the third Friday of each month, European style options stop trading one day earlier, on Thursday preceding the third Friday of the month.
The settlement price is the official closing price for the expiration period, and determines which option is in the money and will be auto exercised. If an option settles in the money by 1 cent or more on expiration date, the odds are very high that the option will in fact be exercised.
The dynamics for exercising options is different between American style options and European style options and is something you need to understand if you want to prevent unnecessary losses to your trading account , especially when trading European style options.
Since the settlement price for European style options is not determined till the opening price on Friday, and the options cease trading Thursday, unforeseen events can occur and can cause the index to open substantially higher or lower than the previous closing price. If you are holding a short position, without off-setting it Thursday before the closing bell, you may find that your option settled in the money, while it closed the day before completely out of the money.
Since no one knows what will happen between the closing on Thursday and the opening on Friday, it’s sometimes best to liquidate your short position and eliminate any chance of settlement risk. Because with European-style options, the settlement price can move either way, which may prove beneficial to some traders and a devastating loss for many others.
Because when the market opens for trading on the morning of the third Friday, there is often a gap - a significant price change from the previous night's close. This doesn't happen all the time, but it happens often enough to turn the apparently low-risk idea of holding a position overnight into a large gamble.
In conclusion, If you decide to trade index options, be certain you understand the differences between American- and European-style options. More importantly, to avoid a significant loss, you must understand how the settlement price of European options is determined.
It makes a big difference to how you manage a position, especially when you have a position that includes short options. It's prudent to stay away from settlement risk by exiting positions that have little more to gain - no later than Thursday, the last day those options can be traded.
Wishing you the best in your trading,