What Is a European Option?

What Is a European Option?

Let me tell you directly: a European option is a type of options contract that you can only exercise on its expiration date. If the underlying security, like a stock, moves in price, you can't jump in early to exercise it and take delivery or sell the shares. Instead, any call or put action happens solely on the maturity date.

Compare this to the American option, which you can exercise anytime up to and including expiration. Don't get hung up on the names—they're not about geography; they just indicate when you can execute.

Key Takeaways

Here's what you need to grasp: a European option restricts exercise to just the expiration day. While American options allow early exercise, that flexibility costs more in premiums, which are often higher than for European ones. You can sell a European option back to the market before it expires and pocket the net difference between the premiums you earned and paid initially. Usually, you don't choose between American or European—most indexes stick with European options. And remember, the Black-Scholes model is commonly used to value them.

Understanding a European Option

European options set the exact timeframe for when you, as the holder, can exercise your rights—buying or selling the underlying asset at the strike price. With these, you only get to do that on expiration day. Like other options, they come with an upfront premium cost.

You should know that you typically can't pick between American and European options for specific stocks or funds; they're offered in one style or the other. Indexes mostly use European options to cut down on brokerage accounting work.

Many brokers rely on the Black-Scholes model to value these European options. Also, European index options stop trading at the close of business on the Thursday before the third Friday of the expiration month, giving brokers time to price the underlying index assets.

This setup can lead to surprises in the settlement price because stocks might move sharply between Thursday's close and Friday's open, and it could take hours after the market opens on Friday for the final price to be published. European options usually trade over-the-counter, while American ones are on standardized exchanges.

Types of European Options

There are two main types: calls and puts. A European call option lets you buy the underlying security at expiry. To profit, the stock price at expiry must be high enough above the strike to cover your premium cost.

A European put option allows you to sell the underlying at expiry. For profit, the stock price needs to drop far enough below the strike to offset the premium.

Closing a European Option Early

Exercising usually means triggering the option's rights for a trade at the strike price, but you might not want to wait for expiration on a European option. Instead, sell it back to the market beforehand.

Option prices fluctuate with the underlying asset's movement, volatility, and time to expiration. If the current premium is higher than what you paid, you can unwind by taking the net difference.

This way, you realize gains or losses on the contract early. Sell a call if the stock has risen a lot, or a put if it's fallen. But closing early depends on market conditions, the premium's intrinsic value, and time value. Near expiration, selling might not yield much because little time remains for gains, so the value hinges on whether it's in, out, or at the money.

European Option vs. American Option

The key difference is timing: European options are exercisable only on expiration, while American ones can be done anytime from purchase to expiry. This lets American option holders profit immediately if the stock moves favorably enough to beat the premium.

You'll see American options used with dividend-paying stocks so investors can exercise before the ex-dividend date to capture the payout. But that flexibility adds a premium on top of the base cost, requiring the asset to move further from the strike for profitability.

If you hold an American option to maturity, you might have been better off with a cheaper European version and its lower premium.

Example of a European Option

Suppose you buy a July call option on Citigroup Inc. with a $50 strike price. The premium is $5 per contract (100 shares), totaling $500. At expiration, if Citigroup trades at $75, you exercise to buy at $50, profiting $25 per share minus the $5 premium, netting $20 per share or $2,000.

If it falls to $30 at expiration, the option expires worthless below the strike, and you lose the $500 premium.

You could wait or sell the option back before expiry. Whether the sale covers your initial $5 depends on economic conditions, company earnings, time left, and stock volatility. There's no guarantee it'll offset the cost.