American vs. European Options
Differences in option exercise styles
Defining American Options
American options are contracts that can be exercised at any time before the expiration date. The holder of an American option has the right, but not the obligation, to exercise at any moment during the life of the contract. That flexibility is the distinguishing feature of American options. In US markets, virtually all single-stock equity options are structured as American options. This feature makes American options more valuable than their European counterparts, all else being equal, because they offer more opportunities for exercise.
Defining European Options
European options are contracts that can only be exercised exactly on the expiration date. The holder cannot exercise before expiry; they must wait until the exact expiration day to exercise or let it expire. Although that sounds restrictive, European options carry a lower theoretical value than equivalent American options. European options trade primarily in international markets and in derivatives markets such as index futures. Most options on broad US indices are European and cash-settled, which eliminates early assignment risk entirely.
Differences in Valuation and Price
Because of the additional flexibility, American options always cost the same as or more than equivalent European options. The price difference reflects the value of the early-exercise capability. For out-of-the-money options that difference is typically small, often just a few cents. For in-the-money options, however, especially near expiration, the difference can be substantial. The price gap is most pronounced for call options on stocks paying high dividends, since the right to exercise before a dividend date carries particular value. Valuation models such as the binomial model were developed specifically to price American options, where early exercise is a live consideration.
Early Exercise: Strategic Considerations
Although the right to exercise early is valuable in theory, in practice most option holders rarely use it. In most cases, selling the option in the market is more profitable than exercising it. There are important exceptions, though. For calls on stocks paying high dividends, it can be optimal to exercise just before the dividend date in order to receive the payment. For deep in-the-money puts, early exercise can be optimal for a specific reason: exercising delivers the cash immediately and that money starts earning interest, which is worth it when there is barely any extrinsic value left to throw away. Institutional traders and market makers use sophisticated algorithms to determine when early exercise is optimal.
Practical Implications for Traders
For most retail traders, the difference between American and European options is mainly theoretical. Traders who buy options will generally find that selling the option in the market is more profitable than exercising. The most important risk for sellers of American options is that their counterparty may exercise early, which removes the chance to benefit from theta decay. That makes selling American options marginally riskier. In addition, when trading international markets, it is important to be aware of whether you are dealing with American or European options, since it affects pricing dynamics and exercise risk.