Explain Option Trading: American vs. European Options
Both puts and calls come in two different varieties. The difference and the effects of these differences are explained here. Fortunately this is not a big deal for most option traders and usually doesn’t affect the value of exchange traded options. As a financial option
trader it’s mostly a matter of being familiar with terminology. As a student you might get asked about it on an exam. But in the OTC markets and in business deals the difference can be big and has to be taken into account. Therefore you have to understand it. It’s explained below.
American and European options explained
American and European options are the same in all respects except when they can be exercised. American options can be exercised at any time up until expiration. European options can only be exercised exactly at expiration time. A call can thus be either an American or European call. A put an American or European put. The names are only names, not an indication of where the option is traded. American and European have nothing to do with geography in option trading.
At first you’d think: Hey, I’d rather have an American option, it gives me more choice! Sometimes this does make the option more valuable. But for exchange traded options it usually doesn’t affect the value one bit. Why? Imagine you have an American option. Say you have a call giving you the right to buy GM at $30 within 30 days. At the time of writing GM trades at $36 so this option is well into the money. You’re considering getting out of your position. But if your option is European you can’t. You have to sit tight and hope the stock price doesn’t go back down before your option expires. So of course you’d rather have an American option. And the choice of when to exercise is clearly worth something. So American options should always be worth more than European to an option trader. Right?
Well, do options actually get exercised before maturity? Exchange traded American options virtually never get exercised before maturity. Why? Say that GM is traded at $36 and your strike $30 call at $8. Thus the intrinsic value of the option is $6 and the time value in option trading explained is $2. What happens to the time value if you exercise the option? Yes, it’s destroyed. You’d be better off selling the option to someone else. So exercising an option would be like saying:-No thank you, I don’t need the time value. -I’ve got enough money as it is.
And as options basically always have time value, it basically never makes sense to exercise them. There are however a number of exceptions. The 3 most important ones are explained below.
Secondary market
This one is very simple. If there is no secondary market, i.e. and exchange, you can’t sell your option. The only way to get out is by exercising. In this case an American option is worth more than a European. Other types of restrictions on the sale of the option would have the same effect. Maybe the option is personal. Imagine your neighbor as given you a call option on a piece of land on the border of your properties. Your neighbor has clearly specified that only you can use the options cause he doesn’t want more neighbors. Just to sell the land. It might be that it’s very difficult and/or costly to find a buyer for the option. This would also make the option worth more if it was American than European.
Puts very deeply into the money
This one only effects put options. Imagine that after the option is written, the price of the underlying falls dramatically. So much that the underlying becomes almost worthless. Say you buy a put option on GM stock. The strike is $26, GM is trading at $36 and there is 30 days to delivery. Then it becomes clear that GM will almost certainly go bankrupt. The stock falls to 5 cents. Now you have $25.95 worth of intrinsic value you could lose but only $0.05 of potential profit. One of the effects of this extreme situation is that the right to exercise becomes valuable and thus American and European options are no longer worth the same. Note that this situation suspends the normal pricing of options issued before the GM crash. Options issued after the crash, with the new much lower strikes, are not effected.
Physical delivery
There might be situations when the physical possession of the underlying is valuable to you. Or it might be costly to store it so you want to get rid of it. This of course only effects options with physical delivery. Also note that most physical goods can be bought or sold in a spot or futures market. So for this aspect to effect value there as to be severe uncertainty as to the supply and demand of the underlying resource. The resource also has to hold a value to you above it’s price. For a financial trader this would not be the case. A good example is a manufacturer which risks running out of raw materials. Without the raw materials the manufacturer can’t produce. This would mean lost profits and pissed off customers. Example: You manufacture solar cells. You have a contract to deliver the cells profitably to a solar panel manufacturer. But pure silicon is in short supply. So short that you might not be able to obtain it. In this situation a purely financial contract would not help you much. You need physical delivery. And to manufacture solar cells now, a European option for delivery of physical silicone in a couple of months will not do much good either. Thus an American option would be worth more to you. And probably to a lot of other companies making silicone based products. In this situation American and European options can’t be priced the same. Note that the advantage/disadvantage of physical possession is related to the cost-of-carry but is not the same.
Summing up the Explanations
In well-functioning financial markets the difference between American and European only matters to put options and only after an extreme price fall.
In the absence of a secondary market other restrictions, an American option is worth more than a European.
When the physical availability of the underlying matters and is very uncertain, the difference between an American and European option can be very important. It thus has to be priced accordingly. The value of possession differs between companies and thus your company’s particular circumstances have to be considered.