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Options: American And European Exercise

Jul. 12, 2013 11:08 AM ET
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Options traders are most familiar with American style exercise. Under this system, used for listed stock options, you can exercise at any time between opening a position and exercise date. But there is a second, more restrictive kind of option, which is European style.

Unlike the American expiration, an option formatted with European style can only be exercised at specific times, often the last trading day in the option's life. In estimating the value of options, the best-known Black Scholes Model is based on a European style exercise. However, all standardized stock options traded on U.S. exchanges trade and are exercised using American style. As a consequence, for many purposes the Black Scholes theoretical model is outdated.

At the time that the Black Scholes modeling paper was published in the early 1970s, only a few calls were available for trading by the public, and only on a handful of stocks. At the time, puts were not publicly traded at all. Trading was awkward and expensive; stockbrokers had to receive an order, usually by telephone, and then make a second call to the exchange to place the trade. Execution could take even more time based on volume levels, so by the time traders got the news of their trade, the price could have changed considerably. Today it has all changed, and options trading is fast and cheap. This also draws the whole assumption documented in Black Scholes into question.

American style provides much greater flexibility for traders, but may also have greater market risks. While most traders know that exercise is most like 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.

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 naturally 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 are going to 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.

To gain more perspective on insights to trading observations and specific strategies, I hope you will join me at ThomsettOptions.com where I publish many additional articles. I also enter a regular series of daily trades and updates. For new trades, I usually include a stock chart marked up with reversal and confirmation, and provide detailed explanations of my rationale. Link to the site at ThomsettOptions.com to learn more. You can take part in discussions among members on the site at the Members Forum.

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