When it comes to investing in options, there are two main styles -- American and European. In many ways, both styles are similar, such as the basic structure of call and put option contracts. However, the major difference between the two has to do with when the option contracts can and cannot be exercised.
How American-style options work
American options allow investors to buy or sell a specific asset, such as a stock or exchange-traded fund (ETF) at a specific price before a specific date. Options to buy a certain asset are known as call options, while options to sell an asset are called puts. Options contracts are generally sold in 100-share increments, although there are some exceptions where options for lower quantities are traded, particularly when it comes to higher-priced stocks.
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The price an option entitles its owner to buy or sell a stock for is known as its strike price. The date when an option ceases to exist is known as its expiration date. Typically, American options expire on the third Saturday of each month, and can be traded through the market's close on the Friday prior.
As an example of how this works, if you buy one call option contract on Microsoft with a strike price of $70 and an expiration in April 2017, this means that you have the right to exercise that option and buy 100 shares of Microsoft stock at any time that the market is open between now and the close of the trading day on the third Friday of April.
The main difference between American and European options
The main difference between the two main styles of options is when they can be exercised. American options may be exercised at any time before their expiration date, while European options may be exercised only at their expiration date, at a single point in time.
For example, let's say that you buy an American-style call option contract on a certain stock, with an expiration date three months in the future and a strike price of $75. If the underlying stock rises to $100 after one month, you have the ability to exercise your option and buy the shares for $75 whenever you want. With European-style options, you have to wait until the expiration date to exercise them and buy the underlying investment.
Its important to mention that in practice, although there are a few exceptions, American-style options are almost never exercised prior to expiration, so this distinction tends not to matter much. If you buy an option and the stock price shoots up, most people would simply sell the option contract to someone else, not exercise it.
Other differences
Another key difference is in the expiration dates of the options. American-style options generally expire on the third Saturday of each month, and the last day to trade them is the Friday prior to this date. European options expire on the Friday before the third Saturday, so their last trading day falls on the Thursday of that week.
American-style options are the more common of the two, and are used for all optionable stocks and ETFs, while stock indexes, such as the S&P 500, may have European-style options available.
The bottom line is that you need to be aware of what type of option you're buying, especially if you're planning to trade or exercise it on its last possible trading day.
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