What is a European Option?
A European option is a type of options contract where the buyer or seller is able to execute the option only at its expiration date. Although it includes “European” in its name, the option is not related to any geographic location. Instead, different kinds of options contracts mean that there are different ways of execution.
Understanding Option Contracts
For example, an American option is a type of options contract that can be exercised at any point during the contract’s duration, which is different from when European options can be exercised. The two kinds of options are call options and put options.
In an options contract, there are several variables that the contract will specify:
- Asset: It may be assets, including foreign currencies, derivatives, or stock indexes.
- Strike price: The price at which the option holder has the right to buy or sell the asset.
- Premium: The price that the buyer and seller need to pay to trade the options contract.
- Maturity date: The date on which the options contract can no longer be exercised.
European Call Option
A call option is when the holder of the contract is allowed to purchase the underlying asset specified in the contract at its strike price on its expiration date. An investor who purchases a European call option makes a profit from the investment only if the asset’s market price is above the strike price at the time of the contract’s expiration.
Therefore, the investor tends to be bullish about the market and expects the asset’s market price to rise above the call option’s strike price. However, if the asset’s market price is below the strike price on the expiration date, then the buyer will not exercise the contract because he/she will not earn a profit to cover the cost of the premium. The contract will expire worthless.
European Put Option
A put option is when the holder of the contract is allowed to sell the underlying asset specified in the contract at its strike price on its expiration date. If an investor sells a European put option, the investor can earn a profit by selling it on the expiration date, when the asset’s market price is lower than the strike price to cover the cost of the premium.
On the other hand, if the asset’s market price is higher than the strike price on its expiration date, then the seller will opt not to exercise the options contract because there will not be a profit. Once again, the contract will expire worthless.
European Option vs. American Option
Unlike American options, which are mainly traded on stock exchanges, European options are usually traded over-the-counter. Since there are different ways of purchasing European and American options, there are varying degrees of accessibility in purchasing each one.
Additionally, since European options only allow the buyer and seller to exercise the options contract at the expiration date, there is no flexibility in terms of when the contract can be exercised. It imposes more risk in terms of profitability because an investor does not have the right to exercise the contract at a point in time where they would make the most profit. Therefore, European options are usually bought and sold at a lower premium compared to American options.
In general, American options are a more popular choice among investors because they provide investors with the ability to exercise the contract any time before the expiration date.
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