European versus American Options
When options trading first began in India, there were two types: European and American. Index options (Nifty and Bank Nifty) were of the European variety, while stock options belonged to the American group. The main distinction between them was how they were exercised.
In the case of European options, the buyer is required to wait until the expiration date to exercise their right. The settlement of the option is determined based on the spot market price at the time of expiration. Unlike American options, which allow early exercise, European options can only be exercised on the expiration date.
For example, if a XYZ Company 3000 Call option was purchased, the buyer requires XYZ Company’s stock price to exceed the break-even point on the expiration day in order to profit from their investment. If this condition is not met, the option will lose all value, resulting in a loss of the premium paid to the option seller.
In American Options, buyers have the liberty to exercise the option at any time during its tenure; settlement is then determined by the current spot market price, rather than on expiration.
Consider the scenario where an individual purchase a XYZ Company 3000 Call option today while XYZ is trading at 2980 in the spot market, with 20 days remaining until the option’s expiration. If the price of XYZ Company rises above 3000 the following day, the buyer has the option to exercise their right, and the seller is obligated to fulfil their obligation. In such situations, the expiration of the option becomes inconsequential.
For those familiar with options, a common question may arise – ‘Given that we can purchase an option and then sell it afterwards, say in 30 minutes, how does it make any difference if said option is American or European?’
This is a valid question. Let’s look at the Rahul-Arjun example again. Instead of Revisiting their agreement in just 6 months, Rahul could have chosen to come whenever during the tenure of the agreement (like an American Option).
For instance, if there was strong rumour about a highway project after they signed off, and the land prices shot up as a result, Rahul could still exercise his right. This would mean Arjun would be obligated to give the land to him, regardless of how much the prices had gone up. Arjun faces higher risk here since he can be called on any day to deliver the land – so he will need a higher premium in order to compensate for this extra risk.
This is why US options are always pricier than European ones.
NSE decided three years ago to completely eliminate American option from its derivatives segment. All options in India now feature European style, which allows the buyer to exercise the option based on the spot price of expiry day.
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