This article explains these differences and their implications. This allows you to find ways to avoid potentially costly problems.
American and European Options: Differences
There are four key differences between American and European options:
- underlying
All optionable stocks and Exchange Traded Funds (ETFs) have American-style options. Among broad-based indices, only a limited number such as the S&P 100 have American-style options. Major broad indices such as the S&P 500 are very active trading European style options.
Examples of European-style options include the S&P 500 Index (SPX), the Russell 2000 Index (RUT) and the Nasdaq (NDX). These are the three most liquid European style options.
- Right to exercise
American-style option holders may exercise their options at any time prior to expiration, while European-style option holders may exercise them only upon expiration.
- Index options trading
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US index options stop trading at the close of business on the third Friday. date of expiry Month. (Some options are “quarterly,” which trades until the last trading day of the calendar quarter, or “weekly,” which ends trading on the Friday of a specified week.)
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European index options stop trading one day earlier at the close of trading on the Thursday preceding the third Friday.
settlement price
This is the official closing price for the life of the contract and indicates which options are in-the-money and subject to automatic exercise. Options that are 1 cent or more in the money on expiration will be automatically exercised unless the option holder specifically requests the broker not to exercise.
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US index options stop trading at the close of business on the third Friday of the expiration month. (Some options are “quarterly,” which trades until the last trading day of the calendar quarter, or “weekly,” which ends trading on the Friday of a specified week.)
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European index options stop trading one day earlier at the close of trading on the Thursday preceding the third Friday.
Here’s how it works:
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The opening price of each stock in the index is determined on the third Friday of each month. Because individual stocks open at different times, some of these opening prices are determined at 9:30 AM EST, while others are determined a few minutes later. Some stocks may not start trading until an hour or two later.
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The underlying index price is calculated as if all stocks were trading simultaneously at their respective opening prices. This is not the actual price. Looking at the published index price, one cannot assume that the liquidation price will be close to the value of the index’s early morning published price.
Exercise
When you own an option, you control your right to exercise it. In some cases it may be beneficial to exercise an option before it expires (for example, to collect a dividend), but it is seldom critical.
If you short an American-style option (sold without owning the option) and are assigned an exercise notice before expiration rather than shorting the option, you have shorted the stock. Unless your account is too small to hold a short position, this is not a problem. If your account is that small, you probably shouldn’t be trading options.
The easiest way to avoid early exercise risks
Initial allocation carries significant risk only for American-style cash-settled index options. Therefore, the easiest way to avoid early exercise risk is to avoid trading American options. When you receive the transfer notice in the morning, you must redeem the option at its intrinsic value the night before. If the market fluctuates significantly, that forced purchase could put you in a different position than you thought you had, exposing you to serious risks.
cash settlement
It’s a win-win for everyone when options are settled in cash.
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American: The settlement price of an American-style option on the underlying (stock, ETF, or index) is generally The closing price or the last trade before the market closes on the third Friday. After-hours trades are not counted when determining the settlement price.
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European: Knowing the settlement price of European style options is not easy. In fact, settlement prices are published hours after the market opens.
These cash-settled options are mostly European-style and allocations are made only at maturity, so the option’s cash value is determined by the settlement price.
settlement
With American-style options, there are few surprises. If the stock is trading at $40.12 a few minutes before its expiry date on Friday, you can expect 40 puts to expire worthless and 40 calls to be in-the-money. If you have a short position with 40 calls and don’t want to be assigned exercise notices, you can buy back those calls. The settlement price could change and these 40 calls could be out of the money, but the value of these calls is unlikely to change significantly in the last few minutes.
Settlement prices are often a big surprise in European style options and while they may be beneficial for some, they are a disaster for many others. opening often creates a gap, which is a large price movement from the previous night’s close. This doesn’t happen all the time, but it happens often enough to turn the seemingly low-risk idea of holding that position overnight into a big bet.
If you own a European option, here’s what you’ll face on Thursday afternoon the day before expiration:
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There is no stock exchange.
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Don’t worry about restructuring complex stock portfolios. Because, like covered call writing and color strategies, you don’t lose stock if a call you write is assigned a strike notice.
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The option owner receives the cash value of the option and the option seller pays the cash value. Its cash value is equal to the option’s intrinsic value. If the option is out of the money, it expires and becomes worthless and has zero cash value.
Shorting options presents another challenge.
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If an option is worth little, it’s not a bad idea to hold on to it and hope for a miracle. Owners of low-priced options worth a few nickels or less can make hundreds of dollars when the markets open the next morning. , or known to earn thousands of dollars. Most of the time, these options expire worthless, but the occasional big reward is possible.
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If you own an option of considerable value (let’s say $1,000), you have to make a decision. Depending on the settlement price, the option may become worthless or double in value. Want to take that risk? It’s a decision only individual investors can make for themselves.
tax
European-style options have a slightly more favorable tax regime as they are subject to the IRS Section 1256 tax regime. This means that 60% of your profits could be counted as long-term capital gains, which is a low rate of 15%. 40% of profits are taxed as ordinary income.
American-style options are taxed as 100% short-term capital gains. Taxes on profits are added as regular income, depending on your overall income and tax amount.
summary
When trading index options, it is important to understand the difference between American-style options and European-style options. More importantly, you need to understand how European options settlement prices are determined to avoid large losses. It makes a big difference how you manage your positions, especially if you have positions that include short options. It is wise to avoid liquidation risk by releasing your position before Thursday, the last day the option can be traded.
Mark Wolfinger has been in the options business since 1977, when he began his career as a floor trader on the Chicago Board Options Exchange (CBOE). Since leaving the exchange, Mark has not only held trading seminars, but also offers individual mentoring via phone, email, and his premium. Options for newcomers blog.Mark published 4 books About options.his Options for newcomers This book is a classic primer and a must read for all options traders. Mark holds a bachelor’s degree from his college in Brooklyn and a PhD in chemistry from Northwestern University.
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