European vs American Option

Publication Date :

01 Oct, 2019

Blog Author :

Edited by :

Reviewed by :

Table Of Contents

Difference Between European and American Option

Whether an option is a European or an American Option depends on the holder's right to exercise it at their will or the pre-decided expiration date. A European option can be exercised only at the expiration date, whereas the American Option can be exercised anytime before the option holder's expiration date. European options are usually traded over the counter (OTC), whereas American Options are traded over a market. Both these styles have pros and cons; it depends on when the option holder wishes to exercise the Option. In this article, we look at their key differences in detail –

Difference Between European and American Option

European options are traded at a lower volume when compared to American options since they are traded heavily.
The premium of a European option is low, and the premium of an American option is high since it allows the liberty of the option holder to exercise the Option at any time before the expiration date.·
Since an American option can be exercised at any time, the risk is higher. In contrast, a European option that can only be exercised on a particular future date has less risk.

What is the European Option?

European Call Option gives the option holder the right to buy a stock at a pre-determined future date and price. The option holder can exercise the Option only when at the expiration date, which has been pre-agreed by the counterparties.

A European Put option gives the option holder the right to sell a stock at a pre-determined future date and price. As mentioned earlier, the option holder can exercise the Option only at the expiration date pre-agreed by both the counterparties at the time of entering the option contract.

Comparing the premium between European and American Options, the former has a lower premium. The holder of a European Option can sell the Option in the market before the expiration date and make a profit from the difference between the premiums.

What is the American Option?

An American Call option allows the holder of the Option the right to ask for the delivery of the security or stock anytime between the execution date and the expiration date when the price of the assets shoots above the strike price.

The strike price does not change throughout the contract in an American Call option. If the Option holder does not want to exercise the Option, they may choose not to exercise it since there is no obligation to receive the security or stock. American call options are usually exercised when they are deep in the money, meaning the asset's price is much higher than the strike price.

An American Put option allows the holder of the Option to ask the buyer for the security of the stock anytime between the execution date and the expiration date when the asset price falls below the strike price. If the Option holder does not want to exercise the Option, they may choose not to exercise it since there is no obligation to sell the security or stock. An American Put option can be deep in the money when the asset's price is much lower than the strike price.

European Option vs. American Option Infographics

Key Differences

European options are traded at a lower volume when compared to American options since they are traded heavily.
The premium of a European option is low, and the premium of an American option is high since it allows the liberty to the option holder to exercise the Option at any time before the expiration date.
Since an American option can be exercised at any time, the risk is higher, whereas a European option that can only be exercised on a particular future date has less risk.

Comparative Table

Basis of Comparison	European Option	American Option
Meaning	The European Option gives the option holder the right to exercise the Option only at the pre-agreed date and price.	American Option gives the option holder the right to exercise the Option at any date before the expiration date at the pre-agreed price.
Premium	Since the option holder of a European Option has the right to exercise the Option only at the expiration date, the premium is low.	The liberty to exercise the Option before the expiration date puts the American Option in more demand, making it pricey.
Popularity	European options are less popular and hence are traded less.	American options are in high demand since it gives the authority to exercise at any time, and hence the majority of the options market are American options.
Risk	European Options have a lower risk since the expiration date is fixed, and the loss or profit can be estimated.	American options have a higher risk since the option holder of an American option has the right to exercise the Option at any time they find it profitable.
Hedging	Formulating a hedging strategy is easier since the option holder can exercise the contract only at a pre-determined date.	Formulating a hedging strategy becomes difficult since the option holder decides the contract's fate.
Trading	They are traded majorly over the counter.	They are traded majorly over an exchange.

Conclusion

European and American Option has a strike price, premium, and expiration date.
An American option is pricey, and the premium is higher than a European option since it gives the option holder the right to exercise the contract at any time after entering the contract and before the expiration date.
Options can be traded on an exchange or over the counter, depending on the counterparties that are involved in the transaction.
American options are most sought after by traders since it gives the trader the right to exit the position at the time, which is highly profitable for them.