What is a European Option?

K.M. Doyle
K.M. Doyle
Businessman with a briefcase
Businessman with a briefcase

In investing, a European option is an option, either a put or a call, that can only be exercised on the option expiration date. This is in contrast to an American option, which can be exercised at any time up to the expiration date. Because there is less flexibility inherent in a European option, it will usually sell for less than an American option on the same security.

An Asian option is another type of option. The Asian option is settled at the average valuation of the underlying security over a period of time, not just at the time it is exercised or at the expiration date. An Asian option is sometimes called an average option. Sometimes an option will be referred to as a vanilla option, which simply means that it has no special features. It has normal terms, including strike price and expiration date.

Consider the three types of options for a single security. An investor can choose a European, American or Asian call option on 100 shares of ABC Company, with a strike price of $20 US Dollars (USD) per share, and an expiration date of 15 June 2011. On 15 March 2011, when the options are purchased, ABC Company is trading at $15 USD per share. On 15 April 2011, it rises to $25 USD per share, and on 15 May 2011 it drops to $10 USD per share. On 15 June, ABC Company is trading at $18 per share. Assume there are no other price changes during the time period.

If the investor chooses the American option, he can exercise it on 15 April and make a profit of $5 USD per share. At any other time, he would lose money and so would not exercise the option. The holder of a European option would only be able to exercise on the maturity date, when the stock is trading at $18 USD per share. Since this would represent a loss, this investor would not exercise his option. If the investor chose the Asian option, the exercise price would be $17.60 USD per share, which also represents a loss, so this option would not be exercised.

The American option represents the most flexibility for the investor, because it can be exercised at any time prior to the expiration date. The risk is that price of the underlying stock will continue to rise after the option is exercised, thereby ‘leaving money on the table.’ The European option and the Asian option have less flexibility, and therefore these types of options tend to sell for less than American options. They also eliminate the risk that the owner could have made more money, because there is only one price at which these options can be exercised.

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Can you sell a put option in a promissory note instead of a stock?

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