What is European Option?
540 reads · Last updated: December 5, 2024
A European option is a version of an options contract that limits execution to its expiration date. In other words, if the underlying security such as a stock has moved in price, an investor would not be able to exercise the option early and take delivery of or sell the shares. Instead, the call or put action will only take place on the date of option maturity.Another version of the options contract is the American option, which can be exercised any time up to and including the date of expiration. The names of these two versions should not be confused with the geographic location as the name only signifies the right of execution.
Definition
A European option is a type of options contract that can only be exercised on its expiration date. This means that investors cannot exercise the option before the expiration date, and buying or selling actions occur only on that specific day. In contrast, an American option allows exercise at any time before the expiration date. It's important to note that these names do not relate to geographical locations but rather to the timing of exercising the rights.
Origin
The concept of European options originated with the development of financial markets, particularly during the standardization of options trading. In the 1970s, as the options market matured, European options became widely adopted as a standardized form of options contract.
Categories and Features
European options are primarily divided into call options and put options. A call option gives the holder the right to purchase the underlying asset at a specific price on the expiration date, while a put option gives the holder the right to sell the underlying asset at a specific price on the expiration date. The main feature of European options is the restriction on exercise timing, which simplifies their pricing model, often using the Black-Scholes model for valuation.
Case Studies
Case Study 1: Suppose an investor holds a European call option on XYZ company stock with a strike price of $50, expiring on December 31, 2025. If on the expiration date, XYZ stock's market price is $60, the investor can exercise the option to buy the stock at $50, realizing a profit of $10 per share. Case Study 2: An investor holds a European put option on ABC company stock with a strike price of $30, expiring on December 31, 2025. If on the expiration date, ABC stock's market price is $25, the investor can exercise the option to sell the stock at $30, realizing a profit of $5 per share.
Common Issues
Common issues investors face with European options include misunderstandings about the exercise timing, thinking they can exercise before the expiration date. Additionally, investors might overlook the impact of market volatility on the option's value. Understanding the exercise restrictions and pricing models of European options is key to avoiding these issues.
