European vs American Options

Overview about option style.

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This is not financial advice.

European vs American Options

European: only execute at expiry. American: execute any time from now till expiry.

In general, they are similar as they're both an agreement where you're not obliged to but can execute based on whatever is written on the contract so the execution is quite similar.

The difference is that the European contract is exercised only at expiry whereas the American contract can be exercised any time.

Execution

If the European contract says that an options contract expires on the 15th of January then it means that you can only execute this agreement on the 15th of January and not before or after this date.

On the other hand, when the American contract says 15th of January it can be executed on or before the 15th of January.

Trade

The European contract is usually OTC or over the counter and this is because you can only execute it on the expiration date and this gives us a very little leeway to play with it. This might not be attractive to a lot of people and hence there isn’t much demand for it. When there's not much demand, you usually get it at OTC counters or OTC trade. It allows you to still have the market makers to be providing these options but they are not as popular.

The popular one is the American kind of options because they're traded more actively. After all, you can execute them anytime and they're traded over the market so you can trade them in bigger markets where you have deeper liquidity and you don't have to just trade them over the counter because OTC can have a slight premium usually in OTC markets whereas traded over the market is a bit more efficient than price discovery.

Premium

The European one has very stringent kind of rules set in place which means that you can only execute it on the expiration date. Not many people are interested in buying that because it's not that attractive and if anything happens before the 15th of January and there is something that could be very beneficial for my trade and I can only execute it on 15th of January. Then maybe that event gets over by then and the option contract is not that valuable anymore. That is one of the problems and so that's why it's slightly cheaper or the premium is slightly lower.

Whereas the American option can be executed anytime and gives so many alternatives to use it so the premium is higher.

Risk

The European contract is a bit more structured as the expiry date is known, the price can be estimated and the premium is also a bit lower and so calculating the price and risk is a lot easier with the European options because most of the things are set in stone.

Whereas it's a bit more difficult with American options because it has a higher risk and can be executed anytime and it's a bit difficult to price this type of options.

Hedging

European options contracts is a bit easier to use to hedge because it's easier to formulate as you know the price and you know when it's going to expire. By that time, you can choose to execute or not and so it's a lot easier to formulate your strategy.

Whereas the American one is a bit more difficult to formulate because you could execute it today you or tomorrow or you could execute it the day of expiry and there are so many alternatives which makes it a bit more difficult to strategize your hedging strategy.

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