American Versus European Options
Options are divided into two wide categories or styles. These are the American style and the European style options. Both types tend to have a lot in common, however, there are some distinct differences to be mindful of as well.
Some of their similarities include the fact that both types of options have a set strike price, as well as a set expiration date. In addition, both option styles are traded on exchanges, and both use somewhat similar structures on their ticker symbols.
The primary difference between American and European style options occurs in the way that investors are able to exercise them. And, all other things being equal with options, the ability to exercise it at any time, rather than just at the expiration date, can greatly affect the option's price.
Most investors are at least somewhat familiar with the American style type of option. Options that are traded on major corporations such as Wal-Mart and GE are American options. With this type of option, an investor is allowed to exercise it at any time they so choose on or prior to the options expiration date.
European options are less familiar to many investors. However, those who trade options on stock indexes like the Nasdaq or the S&P 500 are more than likely trading some European style options.
The big difference between European options from American style options is that an investor may only exercise a European style option at its expiration date. Because of this, European option traders tend to have less risky positions – at least in certain aspects.
In addition, European options tend to be less expensive than American style options. Part of the reason for this is because European option sellers are typically assuming less risk, as there is no worry about an option buyer exercising the option at any time other than on the options expiration date.
On the other hand, the American style of options are generally more expensive due to the American option trader taking on more risk in that it is harder to plan for and hedge their risks when they do not know if or when the purchaser of the option will exercise it.
As an option trader, it is imperative to be aware of the different risk factors that stem from the ability to exercise or not exercise an option at various times. This alone can play a large part in an investor's overall profit potential on that option trade.
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