A European-style option is a type of financial derivative contract known as an option, which gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (known as the strike price) on a specific future date (known as the expiration date). European-style options differ from American-style options in that they can only be exercised at the expiration date, not before.
There are two types of European-style options:
- European-style call option: This option gives the holder the right to buy the underlying asset at the strike price on the expiration date. The holder would exercise the option if the market price of the underlying asset is higher than the strike price, as they can buy the asset at a lower cost and potentially sell it at the higher market price.
- European-style put option: This option gives the holder the right to sell the underlying asset at the strike price on the expiration date. The holder would exercise the option if the market price of the underlying asset is lower than the strike price, as they can sell the asset at a higher price than the current market value.
Key characteristics of European-style options:
- Exercise restrictions: European-style options can only be exercised on the expiration date, which limits the flexibility for the holder to take advantage of favorable market conditions before the expiration date.
- Lower premiums: Due to the restriction on exercise timing, European-style options generally have lower premiums (option prices) compared to American-style options, which can be exercised at any time before the expiration date.
- Trading and settlement: European-style options are traded on various exchanges and can be bought and sold during the life of the contract. However, since they can only be exercised at expiration, the settlement process only takes place at that time.
- Underlying assets: European-style options can be based on various underlying assets, such as stocks, stock indices, commodities, currencies, and interest rates.
- Risk management and speculation: European-style options are used by investors and traders for various purposes, including hedging against potential price fluctuations in the underlying assets and speculating on future price movements.
European-style options offer a more cost-effective and simpler alternative to American-style options for those who do not require the flexibility of early exercise. However, the limited exercise window can also be a disadvantage for some investors, especially in cases of sudden and significant price movements in the underlying asset before the expiration date.