Options 101: American vs. European vs. Exotic
Options provide traders with a valuable tool to gain or limit exposure to a particular asset without actually buying or selling that asset. Option buyers have the right, but not obligation, to buy or sell an asset at a certain price on or before a certain time, while option sellers have the corresponding obligation to fulfill the transaction. Traders most often use options to either gain leverage or hedge against risk.
In this article, we’ll take a look at the different flavors of options available for traders, including American options, European options, and exotic options.
American options are options that can be exercised at any point before their expiration date. For example, a trader might purchase an American option for 100 shares of IBM with a strike price of 100.00 and an expiration date one year into the future, and then exercise it the next week after shares rally. The added flexibility means that these options tend to trade at a premium to European options.
Traders often sell American options into the market rather than exercise them before expiration due to the time value premium, but there are instances where it makes more sense to exercise the option. For example, a put option may be exercised early if the underlying asset files for bankruptcy or an in-the-money call option may be exercised just before a stock pays a dividend.
Valuing American options can be very difficult due to the uncertain exercise date associated with them. Often times, traders use the Black-Scholes price assuming no early exercise occurs and then add a premium depending on the perceived risk of early exercise. The difference between the Black-Scholes valuation and the market price conversely serves as an indicator of the likelihood of early exercise.
European options are stock options that can only be exercised at their expiration date. For example, a trader purchasing a European option for 100 contracts of S&P 500 e-mini futures at a strike price of 1,500.00 and an expiration date one year in the future could not exercise the option if the price of the futures contracts were to rise the following day, although they could sell the option contract itself.
Valuing European options is a very straightforward process using the Black-Scholes or Black Model formulas, which are simple equations with a closed-form solution that has become standardized in the financial community. By comparison, American options do not have a standardized model for valuation, which means that there’s no real consensus on what the options are worth at any given time.
Unlike many American options, European options are also most often index options that are traded over-the-counter rather than on an exchange. Institutions may prefer to use European options due to their cheaper and more certain valuation relative to their American counterparts. Most individual traders, however, trade American options on a daily basis due to the greater flexibility and liquidity.
Exotic options are simply those that do not fit into any category. As their name implies, these options are even more thinly traded than European options and typically involve unusual and difficult-to-value characteristics. Exotic options are usually only traded over-the-counter by institutions, which makes them off-limits to many individual traders sticking to standard exchanges.
For example, an exchange option may offer a trader the right to exchange one asset for another rather than to receive cash, while a basket option uses the weighted average of several underlying assets instead of a single one. The varying underlying assets and dynamics make the options very difficult to value in any standardized way, which makes them difficult to profit from for individual traders.
Some popular exotic options include:
- Lookback Options – Path dependent options where the owner has the right to buy or sell the underlying asset at its lowest or highest price over time.
- Binary Options – Options that pay a fixed amount or nothing at all depending on the price of the underlying asset at the option’s maturity.
- Barrier Options – Options that involve a limiting price whereby the option can be exercised only if the underlying asset crosses it.
- Rainbow Options – Options where the underlying is a basket of assets with the weightings depending on the final performance of the components.
The Bottom Line
Options provide traders with valuable tools for gaining or limiting exposure to a particular asset without buying or selling it. While most individual traders will likely be using American options, they should be aware of the different options available to the market, including European options and exotic options that offer different types of characteristics suited for different situations.
Did you know that...
- Analyzing a stock's 'days to cover' ratio, which relates short interest to average trading volume, can give insights into potential short squeezes?
- 'short covering' is when investors who had bet against a stock (shorted it) decide to buy it to cover their positions, often causing the stock price to rise?
- Dividend reinvestment, where dividends are used to buy more shares of the stock, can significantly boost the returns of long-term investors?
- The 'current ratio' compares a company's current assets to its current liabilities, offering a snapshot of its short-term financial health?
- Risk tolerance refers to an investor's willingness and ability to endure market volatility, guiding how they should allocate assets in their portfolio?
Quotes of the Day:
- "The key to successful investing is to have a plan and stick to it." - Jeffrey Gundlach
- "Investing is not a get-rich-quick scheme, it's a get-rich-slowly scheme." - Robert Rodriguez
- "The investor's chief problem - and even his worst enemy - is likely to be himself." - Martin Zweig
- "We like to buy stocks that have a margin of safety." - Walter Schloss
- "The stock market is a reflection of human nature." - Donald Yacktman
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