One key feature of European-style options is that they can only be exercised on the expiration date, whereas American-style options can be exercised at any time prior to expiration. This means that European-style options can provide greater certainty for traders, as the option’s value is known at expiration and cannot be exercised early.
Explain European-style Options
European-style options are a popular type of financial contract that are commonly used in the trading of stocks, currencies, and commodities. They are often used by investors to hedge their positions or to speculate on the future price movements of an underlying asset.
Types of European-style Options
- Call options:
A call option gives the holder the right, but not the obligation, to buy an underlying asset at a predetermined price, known as the strike price, on the expiration date. If the market price of the underlying asset is above the strike price at expiration, the option is said to be “in-the-money” and the holder can exercise the option to buy the asset at the lower strike price.
- Put options:
A put option gives the holder the right, but not the obligation, to sell an underlying asset at a predetermined price, known as the strike price, on the expiration date. If the market price of the underlying asset is below the strike price at expiration, the option is said to be “in-the-money” and the holder can exercise the option to sell the asset at the higher strike price.
Both call and put options can be used for hedging or speculative purposes, depending on the goals of the investor. For example, an investor might purchase a call option on a stock if they believe the price of the stock will increase, while a put option might be used to hedge against potential losses in a stock portfolio.
European-style options are also used in more complex trading strategies, such as spreads and combinations, where multiple options are used to achieve a specific investment objective.
One key feature of European-style options is that they can only be exercised on the expiration date, whereas American-style options can be exercised at any time prior to expiration. This means that European-style options can provide greater certainty for traders, as the option’s value is known at expiration and cannot be exercised early.
Examples of European-style Options
Example 1: Purchase European Call Options
An investor purchases 10 March call options on Bitcoin with a strike price of $40,000. The premium is $500 per contract for a total cost of $5,000 ($500 x 10 = $5,000). At expiration, Bitcoin is trading at $50,000.
In this case, the owner of the call option has the right to purchase Bitcoin at $40,000, making a profit of $10,000 per Bitcoin. When factoring in the initial premium of $500, the net profit is $9,500 per Bitcoin or $95,000 (10,000 – $500 = $9,500 x 10 = $95,000).
Example 2: Purchase European Put Options
An investor purchases 10 May put options on Ethereum with a strike price of $3,000. The premium is $200 per contract for a total cost of $2,000 ($200 x 10 = $2,000). At expiration, Ethereum is trading at $2,500.
In this case, the owner of the put option has the right to sell Ethereum at $3,000, making a profit of $500 per Ethereum. When factoring in the initial premium of $200, the net profit is $300 per Ethereum or $3,000 (500 – $200 = $300 x 10 = $3,000).
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