American vs. European Options: What’s the Difference?

American vs. European Options: An Overview

American and European options have similar characteristics but their differences are important. Owners of American options may exercise at any time before the option expires. European options can only be exercised at expiration.

Most equity options are American-style options, but many broad-based equity indices have actively traded European-style options, including the S&P 500.

American Options

Options are contracts that derive their value from an underlying asset or investment. They give the owner the right to buy or sell the underlying asset, such as a stock, at a fixed price called the strike price). They can do so on or before a specific expiration date in the future. A call option gives the owner the right to buy a stock. A put option gives the owner the right to sell the stock. The upfront fee, called the premium, is what the investor pays to purchase the option.

Stock options are typically for a single stock. Index options are based on a basket of equities that can represent the equity market as a whole or a portion of the market such as a specific industry. A stock option can be exercised before its expiration date if it’s American-style. An option on an index can only be exercised on its expiry if it’s European-style.

All optionable stocks and exchange-traded funds (ETFs) have American-style options. Only a few broad-based indices have American-style options. American index options stop trading at the close of business on the third Friday of the expiration month, with a few exceptions. Some options are quarterlies and they trade until the last trading day of the calendar quarter. Weeklies cease trading on Wednesday or Friday of the specified week.

The settlement price is the official closing price for the expiration period. It establishes which options are in the money and subject to auto-exercise. Any option that’s in the money by one cent or more on the expiration date is automatically exercised unless the option owner specifically requests their broker not to exercise it.

The settlement price for the underlying asset with American-style options is the regular closing price or the last trade before the market closes on the third Friday. After-hours trades don’t count when determining the settlement price.

There are seldom surprises with American-style options. You can anticipate that 40 puts will expire worthlessly and that 40 calls will be in the money if the stock is trading at $40.12 a few minutes before the closing bell on expiration Friday. You can repurchase those calls if you have a short position in the 40 call and don’t want to be hit with an exercise notice. The settlement price may change and 40 calls may move out of the money, but it’s unlikely the value will change significantly in the last few minutes.

European Options

European index options stop trading one day earlier, at the close of business on the Thursday preceding the third Friday of the expiration month.

It is not as easy to identify the settlement price for European-style options. The settlement price isn’t published until hours after the market opens. The European settlement price is calculated like this:

• The opening price for each stock in the index is determined on the third Friday of the month.
• Individual stocks open at different times. Some of these opening prices are available at 9:30 a.m. ET. Others are determined a few minutes later. 
• The underlying index price is calculated as though all stocks were trading at their respective opening prices at the same time. This isn’t a real-world price because you can’t look at the published index and assume the settlement price is close in value.

Exercise Rights

You control the right to exercise when you own an option. Occasionally, it may be beneficial to exercise an option before it expires to collect a dividend, but it’s seldom important. Dividends are cash payments paid to shareholders by companies as a reward to investors. You sell the option without owning it when you sell an American-style option and you’re assigned an exercise notice before expiration and are short the stock.

The only time an early assignment carries significant risk occurs with American-style cash-settled index options, suggesting that the easiest way to avoid early-exercise risk is to avoid American options. You must repurchase that option at the previous night’s intrinsic value if you receive an assignment notice, placing you at serious risk if the market undergoes a significant move.

Cash Settlement

It’s advantageous to all parties when options are settled in cash due to a few reasons:

• No shares exchange hands.
• You don’t have to worry about rebuilding a complex stock portfolio because you don’t lose active positions if you’re assigned an exercise notice on calls you wrote in covered call writing or a collar strategy.
• The option owner receives the cash value and the option seller pays the cash value of the option. That cash value is equal to the option’s intrinsic value. The option expires worthless and has zero cash value if it’s out of the money.

These cash-settled options are almost always European-style. Assignment only occurs at expiration. The option’s cash value is determined by the settlement price.

Settlement Price

The settlement price is often a surprise with European-style options because a significant price change may occur from the previous night’s close when the market opens for trading on the morning of the third Friday. This doesn’t happen all the time but it happens often enough to turn the low-risk strategy of holding the position overnight into a gamble.

Here’s the scenario faced by European option traders Thursday afternoon on the day before expiration:

• Holding on and hoping for a miracle isn’t a bad idea if the option is almost worthless. Owners of low-priced options that are worth a few nickels or less have earned hundreds or thousands of dollars when the market shifted higher or lower on Friday morning. But these options expire worthless most of the time.
• You have a decision to make if you own an option that has a significant value. The settlement price could make the option worthless or double its value. Do you want to roll the dice? It’s a risk-based decision that individual investors must make for themselves.

You face a different challenge when you short the option:

• Covering is a wise move when you short an out-of-the-money option. You might see the stock approaching the strike and can spend a nickel or two to cover with American-style options. But there are no warnings with European options. Any out-of-the-money option can move 10 or 20 points into the money, costing $1,000 to $2,000 per contract when you’re forced to pay the settlement price. Ask yourself if it’s worth the risk.

The Bottom Line

American-style options typically include stocks and ETFs but many market indices include European options. Trading deadlines and settlement prices are among the more significant differences between these options. Make sure you understand them before wading into one type of option or the other. Seek professional help if you have doubts.