Option trader Michael Thomsett of ThomsettOptions.com lays out the differences between the American and European styles of option exercise—as well as exotic options—and the crucial thing all option traders need to remember before they enter a trade.
Options traders are most aware of American style exercise. Under this system, which is applicable to listed stock options, option owners are allowed to exercise at any time between opening a position and exercise date. But there is a second kind of option exercise, which is European style.
Unlike American style, an option set up under European style can only be exercised at specific times, often right before the last trading day in the option’s life. The Black Scholes pricing model is based on European style exercise. However, all standardized stock options traded on US exchanges trade and are exercised using American style. As a consequence, for many purposes, the Black Scholes theoretical model is outdated, for this and several other reasons.
When the Black Scholes paper was published in the early 1970s, calls were available for trading by the public, and only on 16 stocks. At the time, puts were not publicly traded at all. American style provides much greater flexibility for traders, but may also have greater market risks. While most traders know that exercise is most likely to occur for an in-the-money option on the last trading day, exercise can occur at any time prior. The second most likely exercise date is the last day before ex-dividend date for the underlying stock. The exercising trader times exercise to earn the dividend while also picking up 100 shares of stock at a favorable price. Under the European style—used for most index fund options—strategic exercise by long option holders is not allowed.
Some kinds of exotic options apply terms that are different than both American and European style. For example, exercise rights for a Bermuda option occur on predetermined dates and these days may occur several times. The window of exercise affects the short-term value of this kind of option, making it an interesting hybrid. A similar option, called a Canary option, provides for exercise rights at quarterly dates but only after a specified period (usually one full year) has passed. Another variety, the swing option, gives the long position holders the right to exercise one call only, or one put only, on one or more specific dates. The name comes from the trader’s ability to capitalize on favorable price swings in both directions of the underlying security.
As a general rule, a majority of options traders will deal only with American style options on listed stocks, and European style on over-the-counter stocks, some ETFs, and most indexes available for trading. The most crucial point to remember about the exercise style is to know the terms before opening an option position. If you assume American style and have the intention of moving in and out of an open position whenever conditions are advantageous, you could find yourself severely restricted if the fund or stock trades in the European style. As with all trading products, be sure you know the terms before you trade.
By Michael Thomsett of ThomsettOptions.com
