American and European are the two styles of options contracts. The two styles specify when the options contract can be exercised and have nothing to do with a geographic region. American-style options contracts can be exercised any day on or before the expiration date. For example, U.S. equity options are American-style options.
European-style options contracts can only be exercised on the expiration date. Many index options are European-style options. European-style options cannot be assigned early to the option seller.
What is a European option?
A European option is an option that can only be exercised at its expiration date. The holder of a European option does not have the right to exercise it prior to expiration. The lack of early exercise means that this type of option will usually have a lower premium than an equivalent American style option. It also means that it cannot take advantage of movements in the underlying asset before expiry.
The Black-Scholes model uses European options in its option pricing formula.
What is an American option?
American style options allow for early exercise prior to its expiration date. This gives traders more flexibility as they can choose when to realize their profits or losses. The downside for options sellers is assignment risk.
Differences between European and American Options
The main difference between European and American options is when the option can be exercised. A European option can only be exercised at expiration, while an American option can be exercised at any time before expiration. This makes American options more valuable than their European counterparts because the holder has more flexibility in timing their decision to exercise the option.
Option sellers may prefer European type options, such as index options, to avoid early assignment. European options are cash-settled, meaning cash exchanges hands at settlement instead of an underlying security or physical commodity.
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