European Option: What is European Option?

What is the European Option?

Options are rights (and not an obligation) to buy or sell underlying security like stocks, indices, bonds or even commodities at a prefixed price also called the strike price on, or, by a given day of trade. Now, based on when the transaction can be executed, there are two types of options — American and European options.

European Option Definition

With European options, the owner can only exercise his/her right to sell or buy the stock on the specific date that was mutually agreed upon by both the parties, which is the expiration date of the option contract .

Difference Between European Options and American Options

To understand European options, you must know how the product differs from its American counterpart. In American options, the owner has the right and freedom to buy or sell the security by a specific date. Unlike in American options, these options do not give a longer time frame for selling or buying a stock at a pre-decided price. In other words, while in American options, you can exercise your buying or selling right before expiration, in European options, you can only use the right on the specific date.

Pricing of European options and American options

This also makes a difference in how American and European options are priced. In countries where both the products are available, American options are more expensive than the latter. This is because if the stock price rises or falls, American options allow the buyer or seller of the option to book profits or minimise losses before the contract expires. But, with European options, a trader can only execute the trade at preset prices on the date of expiration of the contract, irrespective of how the prices of the underlying asset have moved.

In India, these options are most commonly traded, and these options expire last Thursday of every month. In a nutshell, European option traders exclusively focus on what they expect the stock prices to be on the day the option contract expires, before buying or selling an options contract.

What is the European call option?

A call option, very simply, is the right to buy a security at a set price on or by a fixed date. More specifically, a European Call option gives the owner a right to buy the underlying asset at a fixed price on the date of the expiry of the contract. The buyer of an option is said to go long on an option.

For example, if trader A is bullish and expects the stock prices of company ABC to settle at a higher price band eventually, he will prefer to lock in the price of the stock when it is low. So if the spot price is Rs. 300 per share and A expects the prices to go up to Rs. 350 in a month for economic or market-driven factors, A may buy a one month European Call option contract of ABC stock at a mutually fixed price of say Rs. 320. Rs. 20 is the premium charged for the call option , which will be pocketed by the seller of the option in any case.

Execution of the trade on the day of expiration

Since it is a one-month call option, precisely one month later on the day the contract expires(Last Thursdays of every month), A can execute his right to buy the stock of ABC company at Rs.320 per share. Now if the spot price of ABC company is trading at anything higher than Rs.320, say at Rs 345, then A will execute his right to buy and purchase ABC shares cheaper by Rs. 25 per share. Similarly, if the spot price does not rise at all and stays at say Rs. 310 on the day the one month option expires, then A would potentially stand to pay Rs.10 more per share if A chooses to execute his right to buy.

What is the European put option?

A European put option is the right to sell a security at a set price on a specific date, or the expiration date. The seller or writer of an option contract is said to be short on an option.

Let us consider an example of a European put option.

If trader B is bearish and expects spot prices of shares of XYZ company to fall dramatically in a month, he would like to hedge his price risks by getting into a put option contract. A put option contract allows B to exercise his right to sell the underlying stock at a pre-decided price on the day the contract expires. If the spot price of XYZ stock is Rs. 500 per share and trader B expects this price to go down to Rs. 300, he would enter a put options contract at a mutually decided price of say Rs. 450 per share. In other words, on the day the contract expires, if the spot price of XYZ stock is anywhere less than Rs.450, let’s assume at Rs. 350, trader B can execute his right to sell the underlying stock at the pre-decided price of Rs. 450, making a decent profit of Rs.100 because the spot prices were lower. But if the market tides change and the price of XYZ stock rises higher, then trader B can choose not to execute his right to sell, that is why it is called an ‘Option’.