WHAT IS AN OPTION?

Option is a financial derivative that gives the buyer the right, but not the obligation, to buy (call option) or sell (put option) an underlying asset at a predetermined price (strike price) within a specified period of time
 

Options Contract specifies the underlying asset, the strike price, the expiration date, and whether it is a call or put option. It grants the holder (buyer) certain rights and the writer (seller) certain obligations.

Exercise is the action of utilizing the right conferred by the option contract to buy or sell the underlying asset at the predetermined strike price.

• It’s the process of buying (in the case of a call option).

• Or the process of selling (in the case of a put option).

AMERICAN & EUROPEAN OPTIONS KEY DIFFERENCES

American Options can be exercised at any time before or on the expiration date.

• Provides more flexibility for the holder to capture favorable price movements of the underlying asset at any time. 

• Typically has a higher premium compared to European options due to this flexibility. 
   

European Options can only be exercised on the expiration date.

• Less flexible as the holder cannot exercise the option before expiration, regardless of how favorable the market conditions might be.
  Usually has a lower premium compared to American options due to these restrictions.
   

PRICING DIFFERENCES

American Options 

• Typically priced using binomial models or other lattice-based models that account for the possibility of early exercise.

• The possibility of early exercise generally results in a higher premium, especially for options on assets with dividends or other factors that might prompt early exercise.

• Requires complex option price modeling to factor in early exercise while also considering the time value of money and dividends.
   

European Options

• Commonly priced using the Black-Scholes model, which assumes the option can only be exercised at expiration.

• Generally has a lower premium compared to American options, as there is no possibility of early exercise.

• The pricing is simpler since it only needs to consider the value at expiration, without accounting for early exercise possibilities.
   

KEY FEATURES

American Options

• Exercise Flexibility: can be exercised at any time before or on the expiration date.

• Higher Premium: Typically commands a higher premium due to the added flexibility of early exercise.

• Dividend Consideration: More advantageous for options on dividend-paying stocks as holders can capture dividends by exercising early.
   

European Options

• Exercise Restriction: Can only be exercised on the expiration date.

• Lower Premium: Generally has a lower premium compared to American options due to the lack of flexibility.

• Strategic Use: Often used in structured products and index options where early exercise is less critical.

AMERICAN OPTIONS & EARLY EXERCISE FEATURE

Early Exercise Feature is the ability to exercise at any time increases the option's value because it allows the holder to capitalize on favorable price movements or capture dividends by exercising early. This flexibility reduces the risk of missing out on potential profits, thereby increasing the premium.

• Only unique to American options & Bermudan Options

AMERICAN OPTIONS EXAMPLE

American Options Exercise Scenario: An investor buys a $30 strike American call option in April with a six-month expiration period. 

The stock price rises to $60 three months later in June and the investor decides to exercise his option at the set strike price of $30 per share, costing a total of $3,000 and the investor is left with two options:

1. Hold the underlying shares: In speculation of greater potential price movement.

2. Sell the underlying shares: At the market price of $60 per share, earning $6,000 and realizing a profit of $3,000.
    

Investors can also purchase put options, which give them the right to sell rather than buy. In the case of put options, the investor would exercise their right to sell if the asset's value declines.

EUROPEAN OPTION EXAMPLE

European Options Exercise Scenario: An investor buys a $30 strike European call option in April with a six-month expiration period. Unlike American options, European options can only be exercised at expiration.

The stock price rose to $60 three months later in June. However, the investor cannot exercise the option yet as it is a European style option.

The stock price then falls back to $45 three months later on the options expiration date of October, and the investor is left with two options:

1. Hold the underlying shares: In speculation of greater potential price movement.

2. Sell the underlying shares: At the market price of $45 per share, earning $4,500 and realizing a profit of $1,500.
    

Investors can also purchase put options, which give them the right to sell rather than buy. In the case of put options, the investor would exercise their right to sell if the asset's value declines. For European put options, this would also occur only at expiration.

In conclusion, understanding the differences between American and European style options is crucial for navigating the complexities of the financial markets. American options offer flexibility with their early exercise feature, allowing investors to capitalize on favorable price movements or capture dividends before expiration. On the other hand, European options provide simplicity with their restriction to exercise only at expiration, often at a lower premium. Whether you're considering trading on exchanges or over-the-counter, recognizing these differences is key. We trust that this guide has provided clarity on these concepts. Thank you for investing your time with us.

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