A European option is that financial option where the buyer of the same can exercise it only when the contract expires.
In other words, if the underlying asset moves in favor of the option buyer before expiration, they will not be able to benefit from exercising it. Because of this, you would have to wait for the end of the option contract to see if you exercise your right or not. Unlike the case of American options, which can be exercised at any time before expiration.
Operation of a European option
The European option contract has a number of characteristics that help us understand how it works in practice. Let's talk about the most important ones.
On the one hand, the buyer of a European option will have the right to buy or sell the underlying asset at maturity and with a previously established exercise price. And, to obtain this right to exercise, you must pay a premium.
On the other hand, and in the event that the buyer exercises his right to expiration, the seller of the option will be obliged to buy or sell the underlying asset. Where the seller will be rewarded with the premium paid by the buyer.
Therefore, the factors to take into account to understand the operation of a European option are: buyer, seller, premium, exercise price, expiration date, and type of option (explained below).
Types of European options
We have two types of European options: call option and put option. We will explain them below:
- European call option. It gives the right to its owner to buy a certain underlying asset at the expiration of the option at the established strike price. And, therefore, it gives the seller the obligation to sell the underlying asset if the buyer exercises this right.
- European put option. It gives the right to its owner to sell the underlying asset at maturity at the agreed strike price. And in the case, that the buyer exercises this right, it generates the obligation to the seller to buy the underlying asset.
Advantages of a European option
Let's see the advantages that European options have in relation to other types of options, such as American options:
- Lower cost of the premium. Due to the restriction that investors have in having to wait for the expiration to exercise the option, the premiums are usually lower than the American options. Since, in these, the investor can exercise the option at any time.
- Possibility of investing in stock indices. Most stock indices use European and non-American options. Which means that, if we want to invest in indices via options, we will have to acquire European options and we can only exercise the Call or Put at maturity.
Disadvantages of a European option
Among the disadvantages that the European options present in relation to the American ones, we will highlight two:
- Exercise restriction. The buyer of European options can only exercise his right to expiration. This, perhaps, is the most remarkable characteristic in relation to another type of option.
- Low liquidity. While American options are usually traded in organized and standardized markets, European options are normally traded in OTC markets. This means that these types of options have less liquidity than that of an asset that is traded in an organized market.