American Options vs. European Options

When considering the difference between American options versus European options, it is important to keep in mind that there are several levels of analysis possible because they  range from the most straightforward to highly complex mathematical anomalies. A full interpretation of an option requires both an understanding of options contracts and an appreciation of statistical subtleties.

Differences in Exercise Ability

The most basic difference between an American option and a European option is that a European option may only be exercised on the expiration date, while an American option may be exercised at any point before that date. All options give the holder the option, but not the obligation, to buy (in the case of a call) or sell (in the case of a put).

This right has a value that is based on several factors, including the amount of time until the expiration date, the difference between the current price of the underlying relative to the strike price, and a number of other factors.

With a European option, the holder may only make complete the transaction allowed by the option contract at the expiration date. An American option allows the flexibility to make the transaction at any point in time prior to expiration. In addition to the added flexibility, this feature implies that an American option will always be worth at least as much as an otherwise identical European option, and will be worth more in some cases.

Differences in Value

Typically, because an option’s value is based largely on the amount of time left until expiration, the holder of an option usually prefers to close the option position rather than exercise the option. There are rare instances, however, when the owner of an American option will prefer to exercise the option rather than close the position.

For example, just before the underlying stock pays a dividend, if the option’s value falls by more than the remaining value, it is advantageous to exercise the option. Because of the anomalous instances, calculating the value of an American option can be difficult.

Essentially, while a European option can be accurately valued using the famous Black-Scholes pricing model, American options require a more complex pricing model. What most traders need to understand is that an American option will always be worth at least what a European option is worth.

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