American Options Investors: Should You Go Euro?

February 26 2009| Filed Under » , , , ,
Just as there are two different types of options (puts and calls), so there are two main styles of options: American and European. These options have many characteristics in common, but it's the differences between them that are important. Many rookies, as well experienced traders, have suffered unnecessary losses because they were unaware of the differences. In this article, we'll discuss these differences and how they affect you, so you can discover how to avoid potentially costly problems. (For background reading, see How do you tell whether an option is American or European style?)

  1. Underlying
    All optionable stocks and exchange-traded funds (ETFs), such as the SPDR Trust (SPY) and the Nasdaq 100 Trust (QQQQ) have American-style options. Among the broad-based indexes, only the S&P 100 index (OEX) has American-style options.

    Major broad-based indexes, such as the S&P 500 (SPX), Nasdaq 100 (NDX) and Russell 2000 (RUT), have very actively traded European-style options.

  2. The Right To Exercise
    Owners of American-style options may exercise at any time before the option expires, while owners of European-style options may exercise only at expiration. (For a refresher on exercising and other options fundamentals, see our Options Basics tutorial.)

  3. Trading
    • American options cease trading at the close of business on the third Friday of the expiration month. (A few options are 'quarterlys', which trade until the last trading day of the calendar quarter or 'weeklys', which cease trading Friday of the specified week.)
    • European options stop trading one day earlier - at the close of business on the Thursday preceding the third Friday.

  4. Settlement Price
    This is the official closing price for the expiration period and establishes which options are in the money and subject to auto-exercise. Any option that's in the money by $0.01 or more on the expiration date is automatically exercised unless the option owner specifically requests his/her broker not to exercise. (To read more on executing a trade through a broker, see The Nitty-Gritty Of Executing A Trade.)
  • American: The settlement price for the underlying asset (stock, ETF or index) with American-style options is the 'regular' closing price, or the last trade before the market closes on the third Friday. After-hours trades do not count when determining the settlement price.
Here\'s how it works:
  • On the third Friday of the month, the opening price for each stock in the index is determined. Because individual stocks open at different times, some of these opening prices are determined at 9:30am (EST) and others a few minutes later. Some stocks may not begin trading until an hour or two later.

Exercise Rights
When you own an option, you control the right to exercise. Occasionally, it may be beneficial to exercise an option before it expires (to collect a dividend, for example), but it's seldom important. (Learn more in Dividends, Interest Rates And Their Effect On Stock Options.)

When you are short an American-style option (you sold the option without owning it) and are assigned an exercise notice prior to expiration, instead of being short the option, you are now short the stock. Unless your account is too small to carry a short stock position, this is not a problem, and if your account is that small, you should probably not be trading options. (Read more in Options Hazards That Can Bruise Your Portfolio.)

The only time an early assignment carries any significant risk occurs with American-style, cash-settled index options. The only such options are OEX, so the easiest way to avoid the early-exercise risk is to avoid trading OEX options. When you receive an assignment notice in the morning, you must repurchase that option at the previous night's intrinsic value. That may place you at serious risk if the market undergoes a significant move, because that forced purchase makes your position different from the one you thought you owned. (To learn more, read Understanding Option Pricing.)

Cash Settlement
It's advantageous to everyone when options are settled in cash:
Because these cash-settled options are almost always European-style, and assignment only occurs at expiration, the cash value of the option is determined by the settlement price.

Settlement Price

With European-style options, the settlement price is often a huge surprise, which may prove beneficial to some, but a disaster for many others. That's 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 that position overnight into a large gamble.

  • If you own an option that has a significant value - let's say $1,000, or an option premium of $10 - you have a decision to make. The settlement price could make the option worthless or double its value. Do you want to take that risk? That's a decision only individual investors can make for themselves.
When short the option, you face a different challenge:
  • When short an out-of-the-money option, covering is a wise move. With American-style options, you see the stock approaching the strike and can spend a nickel or two to cover. But with European options, there are no warnings. Any out-of-the-money option can move 10 or 20 points into the money - and that would cost $1,000 to $2,000 per option when you are forced to pay the settlement price. It's not worth the risk.
If you decide to trade index options, please be certain you understand the differences between American- and European-style options. More importantly, to avoid a significant loss, it's essential that you 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.
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