When options trading first commenced in India, two types existed: European and American. Index options (Nifty and Bank Nifty) were of the European variety, whilst equity options belonged to the American group. The principal 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 Reliance Industries 2,400 Call option was purchased, the buyer requires Reliance Industries’ equity 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 purchases a Reliance Industries 2,400 Call option today whilst Reliance trades at 2,350 in the spot market, with 20 days remaining until the option’s expiration. If the price of Reliance Industries rises above 2,400 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 Vikram-Suresh example again. Instead of revisiting their agreement in just six months, Vikram 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 motorway project after they signed off, and the property prices shot up as a result, Vikram could still exercise his right. This would mean Suresh would be obligated to give the property to him, regardless of how much the prices had gone up. Suresh faces higher risk here since he can be called on any day to deliver the property, so he will need a higher premium in order to compensate for this extra risk.
This is why American options are always pricier than European ones.
NSE made a decision several years ago to completely eliminate American options 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.
For those exploring equity investment opportunities through a stock broker or consulting with a financial advisor, understanding the distinction between European and American options proves essential when navigating the stock market. Whether evaluating trading calls or utilising a stock screener to identify opportunities, recognising these fundamental differences enables more informed decision-making in options trading.
Visit https://stoxbox.in/ for comprehensive educational resources on options trading styles and market mechanisms.
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