Trading in options has been geared up for the last few years and if you are an old player in an Algorithmic trading game you might be familiar with the two terms American options and European options. If you are new in the market you must know about these two terms.
Options trading can be seen as intimidating for beginners and option trading can be a risky endeavor but with a little understanding of the basics and best options trading app you can be a good player in this market. What you have to do is take baby steps and then run into the market.
By having an understanding of the basic terms, strategies, and types you can win the battle. Now let's start now gaining knowledge about American options and European options and the key differences between them.
Well, American and European style options are not regionally exclusive option contracts. You can trade them from any part of the world but it is necessary to understand the difference between them.
The American option is a popular and widely used option across the world. An American option is a type of contract that gives the right but not the obligation to buy or sell securities in the future at a specific date and at any time on or before the contracts expire.
Thus, the American call option allows the buyer of the option to deliver the security at any time between the execution date and the expiration date. When the price of a security is higher than the strike price.
This also means that American call options are usually exercised when the asset price is more than the strike price and the same is the case with American put options, it allows the holder of the option to sell the security at any time between the execution date and expiration date. When the price of a security is lower than the strike price.
Also, American put options are usually exercised when asset prices are less than the strike price. Thus we conclude that settlement depends upon the spot market at that given time and does not depend on stock expiration. In the US, stock options generally have an expiration date between 3 months and 1 year.
Read More: What Are The Different Types of Derivatives?
The European option is slightly different from the American option. The European option is a type of contract that gives you the right but not the obligation to buy or sell the security in the future only at the expiration date.
Thus, European options are different as they cannot be exercised before the expiration date.
Now let's understand the difference between the American option and the European option
Difference Between The European Option and The American Option
Here are some key differences between the American option and the European option:
1: Exercise Right
As discussed earlier, the date of exercise of rights varies between American and European options, American option can be redeemed at any point between the date of the purchase option expiry date while the European option can be exercised only on the date of expiry.
2: Stop Trading
European options stop trading a day prior to American options. American options stop trading on the 3rd Friday of each month. But European options end one day prior on Thursday, before the third Friday of the expiration month.
Premium tends to be lower in European options as European options have the right to exercise their option only at the expiration date. Premium is higher in American options as American options are more in demand and popular as it provides flexibility to exercise options before the expiration date.
American options are more popular as compared to European options. As European options are traded less hence the majority of the options market is of American options only.
European options have lower risk as it is exercised on the expiration date and as the expiration date is fixed the profit or loss can be estimated. American options are at high risk as compared to European options as traders with an American option liberty to exercise their right at any time before expiration when they think that the market is profitable for them.
6: Hedging Strategy
Implementation of the hedging strategy in the European option is easier as the holder can exercise his rights only at the expiration date while Implementation heading strategy in the American option is quite difficult since the American option can be exercised at any point during the contract period and as option contract fate lies in holder's hand.
European options are traded majorly over the counter ( OTC ), while American options are majorly traded over an exchange.
8: Underlying Asset
The underlying assets in the American option are related to individual stocks, equity, and ETFS, etc while the underlying assets in the European option are related to indices.
As European options are related to indices, they are settled In cash while American options are related to individual stocks and ETFs can be settled in stock or cash.
10: Settlement Price
The settlement price for European options is the opening price of index components while the settlement price for American options is the last closing trade price.
As American options are more popular and in demand, they have higher trading volume as compared to European options.
12: Pricing Models
The best-known pricing model for options trading is Black Scholes model which can be considered for European options but inaccurate for some American options. As this model does not consider early exercise.
While American options formulating binomial option pricing models are more favor
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