Papale on European vs. American

By Steve Papale

I love this time of year.  Warm, dry days.  Cool nights.  Open windows.  Clean, crisp air.  The smell of skunk.  Yep.  It seems a skunk has taken up residence or at least is hanging around near our house and there is no mistaking it.  I thought my 16 year old son had some bad smells coming from him but this skunk is really nasty.  I’ve only seen it once but we know when it is nearby.  Hoping when the weather gets cold that will take care of it but in the meantime we open our windows at our own risk.  Now I need to decide what is worse – skunk or 16 year old.

When it comes to option exercise, there are two types – American and European.  American options can be exercised anytime  the owner wants up to and including expiration day.  All stock options are American.  European options in contrast can only be exercised at expiration.  There is no early expiration possibility.  Many indexes like SPX, NDX and RUT are European when it comes to their options.  There are pros and cons to both type of options.

European options where there is no risk of early exercise can be valuable to anyone who does not want to risk of early assignment.  This is especially useful for large players where they might be short in the money options against other positions.  An early exercise of these positions could cause any hedged position to have potentially large risk exposure.  SPX is largely an institutional product developed so hedgers and managers could put on positions and know they would be there until expiration.

In contrast, American options can be exercised anytime.  While in theory this is true, in reality it is quite easy to predict when options will be exercised.  With calls, the only time it is economically advantageous to exercise early is ahead of the ex-dividend date.  Remember, call owners, while they can participate in the upward movement of stocks, they cannot collect a dividend.  So call holders might exercise to collect the dividend.  And they do this only when the dividend they collect is greater than the remaining extrinsic value left in the calls.  This is because when calls are exercised the holder loses all remaining extrinsic value.  That all said of course anyone can exercise their call anytime they want.  But if your short a call and it gets exercised and it was economically unexpected, it most likely will be a windfall for the call seller.  Puts are exercised only when it makes more sense to be short the stock than synthetically short via the put.   This occurs in higher interest rate environments where traders can collect more dollars in interest from the cash generated from short stock than the equivalent position using options.

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