American And European Options

There are two fundamental kinds of options: the American option and the European option. An American option permits the owner to exercise at any time before or at expiration. The owner of a European option can exercise only at expiration. Thus, the two kinds of options differ because the American option permits early exercise. To this point, we have considered option values only at expiration. If the option is at expiration, American and European options will have the same value. Both can be exercised immediately or be allowed to expire worthless. Prior to expiration, we will see that the two options are conceptually distinct. Further, they may have different values under certain circumstances. In this chapter, and through the remainder of the book, we will need to distinguish the principles that apply to each kind of option.

Consider any two options that are just alike, except one is an American option and the other is a European option. By saying that the two options are just alike, we mean that they have the same underlying stock, the same exercise price, and the same time remaining until expiration. The American option gives its owner all the rights and privileges that the owner of the European option possesses. However, the owner of the American option also has the right to exercise the option before expiration if he desires. From these considerations, we can see that the American option must be worth at least as much as the European option.

The owner of an American option can treat the option as a European option just by deciding not to exercise until expiration. Therefore, the American option cannot be worth less than the European option. However, the American option can be worth more. The American option will be worth more if it is desirable to exercise earlier. Under certain circumstances, which we explore later, the right to exercise before expiration can be valuable. In this case, the American option will be worth more than the otherwise identical European option. /"

In some cases, the right to exercise before expiration will be worthless. For these situations, the American option will have the same value as the European option. In general, the European option is simpler and easier to analyze. However, in actual markets, most options are American options. This is true both in the United States and throughout the world. We should not associate the names "American" and "European" with geographic locations. In the present context, the names simply refer to the time at which holders can exercise these options.

WHY TRADE OPTIONS?

Options trading today is more popular than ever before. For the investor, options serve a number of important roles. First, many investors trade options to speculate on the price movements of the underlying stock. However, investors could merely trade the stock itself. As we will see, trading the option instead of the underlying stock can offer a number of advantages. Call options are always cheaper than the underlying stock, so it takes less money to trade calls. Generally, but not universally, put options are also cheaper than the underlying goods. In relative terms, the option price is more volatile than the price of the underlying stock, so investors can get more price action per dollar of investment by investing in options instead of investing in the stock itself.

Options are extremely popular among sophisticated investors who hold large stock portfolios. Accordingly, institutional investors, such as mutual funds and pension funds, are prime users of the options market. By trading options in conjunction with their stock portfolios, investors can carefully adjust the risk and return characteristics of their entire investment. As we will see, a sophisticated trader can use options to increase or decrease the risk of an existing stock portfolio. For example, it is possible to combine a risky stock and a risky option to form a riskless combined position that performs like a risk-free bond.2

Many investors prefer to trade options rather than stocks in order to save transaction costs, avoid tax exposure, and avoid stock market restrictions.3 We already mentioned that some investors trade options to achieve the same risk exposure with less capital. In many instances, traders can use options to take a particular risk position and pay lower transaction costs than stocks would require. Likewise, specific provisions of the tax code may favor options trading over trading the underlying stock. If different traders face different tax schedules, one may find advantage in buying options and another may find advantage in selling options, relative to trading stocks. Finally, the stock and options markets have their own institutional rules. Differences in these rules may stimulate options trading. For example, selling stock short is highly restricted.4 By trading in the options market, it is possible to replicate a short sale of stock and avoid some stock market restrictions.5

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Responses

  • anu
    Why are american option cheaper then european?
    8 years ago

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