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American vs European vs Bermudan Options

Know how they are different from one another

What are American vs European vs Bermudan Options?

There are different types of options that differ in terms of their exercise restrictions. The three basic types are American, European, and Bermudan options. Let’s explore American vs European vs Bermudan options to find out how they are different from one another.

 

American vs European vs Bermudan Options

 

Options are exactly what they sound like – a choice for investors using the stock market. They give investors the choice, but no obligation, to either buy an asset (with a call option) at a predetermined strike price or sell an asset (with a put option) for a specified strike price. Options come with a set period of time during which the option can be exercised and a date when the option is no longer valid (expiration date).

 

Summary 

  • Options are either calls (where the trader can buy shares for a specified strike price) or puts (where the trader can sell short at the specified strike price).
  • American options allow a trader to exercise their buy or sell an option at any time before the option’s expiration date.
  • European options specify that a trader can only choose to exercise (or not) his option on the date of expiration.
  • Bermudan options allow a trader to exercise his option on any of several specified dates before the option expires; thus, Bermudan options are sort of a middle ground between American and European options.

 

What are American Options?

American options are arguably the best known and most widely used. They include, of course, call and put options. Stock options in US stock markets typically have an expiration period of between three months and one year.

Let’s look at an example. An investor who purchased an American call option in January knows that his option will expire in April. The exact date of expiration is known and is listed in the option contract. His option specifies that he can purchase stock in Company ABC for $30 per share. $30 is the option’s strike price, the price at which the option can be exercised. The value of the option will change, moving in sync with the underlying asset.

The trader sees that the price of the stock is continuing to rise. The stock price climbs to $60 by the end of March. He exercises his option and purchases 100 shares of the stock at the $30 strike price for $3,000. He then turns around and sells his shares at the current market price, receiving $6,000 from the sale (100 shares x $60 per share). He’s made a profit of $3,000 because he was able to sell his shares for double the amount that he purchased them for.

American options are widely used because they offer the most flexible exercise schedule: they can be exercised on any trading day prior to their expiration.

 

What are European Options?

European options are different because they can’t be exercised before the expiration date. In other words, they can only be exercised on one specific date, which means that traders enjoy much less flexibility in how they handle option trading.

For example, an investor buys a European call option to buy 100 shares of Company ABC, with a strike price of $30 and an expiration date in April. He sees the shares climb to $60 by mid-February. However, unlike the holder of an American-style option, he does not have the freedom to exercise his option at that time – he can only exercise it upon expiration.

Unfortunately, by the time the option’s expiration, or maturity, date rolls around, ABC stock has fallen to $35 a share. He can still exercise his option profitably on the expiration date – buying 100 shares at the $30 strike price and promptly selling them for $35 a share, but his profit is only $500. To determine his net profit, he must subtract the premium, the price he paid for the option, from his $500 gross profit.

European options, for this reason, are typically considered less valuable than American options, and can, therefore, usually be purchased at a discount. Another difference from American options is that European-style options are typically traded over-the-counter (OTC) rather than on an exchange.

It’s important to note that while traders of European options are limited in terms of when they can exercise options, they are still free to sell their options to another trader in the secondary market prior to the option’s expiration. In the example above, the European option trader could’ve realized a significantly higher profit from merely selling his option when the price of the underlying stock surged to $60.

 

What are Bermudan Options?

Bermudan options are different from both American and European options. The contract for a Bermudan-style option denotes specific days before expiration on which the trader can exercise his option. The specified exercise dates are usually near the time of the option’s expiration date. Thus, Bermudan options fall in between American and European options in terms of how much freedom a trader has to exercise the option.

Let’s use the same scenario as above, that of a trader purchasing a call option on 100 shares of Company ABC stock, with an expiration date in April. A trader with a Bermudan call option can elect to buy shares of Company ABC for $30 per share ($30 is the strike price used in all the examples above).

The only caveat is that he can only exercise his option on four specified days in April, as laid out in the option contract. He has more freedom of exercise than he would with a European option, but still considerably less freedom than he’d have with an American option.

 

Related Readings

CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful:

  • Options: Calls and Puts
  • Put-Call Ratio (PCR)
  • Secondary Market
  • Trading Mechanisms

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