What is a European Option?

A European option is the type of options contract that allows investors to exercise their options only on the expiration date of that contract. The contract holder has the right to buy or sell the underlying securities for a specified price; it is known as the strike price of the option.

European alternatives are less adaptable than their American counterparts, but they are more predictable. This article will explain how European options function and how they can be added to an investor's portfolio.

European Call Option Explained

A European option is the type of options contract that allows the option holder to exercise the option only on the expiration date of the option. Option holders have the right but not the obligation to exercise their options. They can also choose not to use the option and let it expire.

The option holder can exercise a call option to buy shares at the strike price if it is a call option. They can execute the option to sell shares if it's a put.

Types of European Options

There are two types of European options, and they are:

  1. European Call Option: The owner of a European call option has the right to buy the underlying security at expiration. To profit on a call option, the stock's price must be trading sufficiently above the strike price at expiration to pay the cost of the option premium.
  2. European Put Option: The holder of a European put option can sell the underlying security at expiration. To profit from a put option, the stock must be trading far enough below the strike price at expiration to cover the cost of the option premium.

What is the Difference Between a European Option and an American Option?

Alternatives to European alternatives are primarily available in the United States. When the option holder can execute the contract is the key difference between the two.

European Option

American Options

It is practicable only on the expiration date.

It is exercisable any time before the expiration.

It has less flexibility, and they are generally worthless and have a lower premium when compared to the American options.

It has more flexibility, which means they are generally worth more and commands a higher premium compared to the European options.

Usually, some index options that are available in the US are European options.

Typically, most US stock options are American options. Usually, they are traded on exchanges.

The formula for European Call Option: Price Call = P0N(d1) – Xe-rtN(d2)

Formula for European Put Option: Price Put = Xe-rt *(1-N(d2)) – P0*(1-N(d1))

 

Benefits of European Style Options

  • While European options are less dangerous than American ones, they are not without risk. They could be exposed to various potential dangers. In order to avoid such dangers - it is necessary to take a cautious approach.
  • The danger of a trading lapse is one such risk. Trading in European options closes at the end of the business day on a Thursday preceding the expiration month's third Friday. This can result in an unanticipated shift in the underlying price.
  • Due to the danger of trade lapses, determining the settlement price may be difficult.
  • Investors are unable to exercise their options in order to profit from a favourable price movement.
  • Since the majority of these options are traded over the counter, there isn't much regulation, which adds to the danger.

 

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