European style options: Meaning, Criticisms & Real-World Uses

What Are European Style Options?

European style options are a type of options contract that grants the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined strike price on a specific expiration date. A key characteristic distinguishing European style options within the broader category of financial derivatives is that they can only be exercised at maturity, not at any time before. This contrasts with other option styles that allow for earlier exercise. The simplicity of their exercise feature makes them a foundational instrument in the financial market for various strategies including hedging and speculation.

History and Origin

The modern options market, and by extension, European style options, have their roots in the establishment of formal exchanges for standardized derivatives. Before the 1970s, options were primarily traded over-the-counter (OTC) with customized terms. A pivotal moment in the history of options trading occurred with the founding of the Chicago Board Options Exchange (CBOE) in 1973. This institution was the first exchange to list standardized, exchange-traded stock options, revolutionizing the accessibility and liquidity of these financial instruments.,¹³ The CBOE’s creation provided a central marketplace for options, moving them from a complex, direct buyer-seller interaction to a more organized and regulated environment. T¹²he development of pricing models, such as the Black-Scholes model, which was specifically designed for European style options, further cemented their theoretical framework and facilitated their widespread adoption in financial markets.

Key Takeaways

European style options can only be exercised on their specified expiration date, not before.
They are a fundamental type of derivative used for both risk management and taking directional market views.
The pricing of European style options is often determined using mathematical models like the Black-Scholes formula.
Due to their fixed exercise date, they can be simpler to analyze and value compared to options with flexible exercise periods.

Formula and Calculation

The most widely recognized formula for pricing European style options is the Black-Scholes model, developed by Fischer Black and Myron Scholes in 1973. This model provides a theoretical value for options, particularly for those that can only be exercised at maturity.

¹¹For a European call option, the formula is:

C = S_0 N(d_1) - K e^{-rT} N(d_2)

For a European put option, the formula is:

P = K e^{-rT} N(-d_2) - S_0 N(-d_1)

Where:

(C) = Theoretical price of the European call option
(P) = Theoretical price of the European put option
(S_0) = Current price of the underlying asset
(K) = Strike price of the option
(T) = Time to expiration (in years)
(r) = Risk-free interest rate (annualized)
(N(x)) = Cumulative standard normal distribution function
(e) = Euler's number (approximately 2.71828)
(d_1) and (d_2) are calculated as:

d_1 = \frac{\ln(\frac{S_0}{K}) + (r + \frac{\sigma^2}{2})T}{\sigma \sqrt{T}}

d_2 = d_1 - \sigma \sqrt{T}

Where:

(\ln) = Natural logarithm
(\sigma) = Volatility of the underlying asset

This formula helps determine the fair option premium based on these inputs.

Interpreting European Style Options

The interpretation of European style options centers on the expectation of the underlying asset's price movement relative to the strike price at the specific expiration date. Because early exercise is not permitted, the option's value before maturity is purely its time value and intrinsic value (if any). Investors holding European style options must anticipate whether the underlying asset will be above the strike price for a call, or below the strike price for a put, exactly on the expiration date. This makes them suitable for investors who have a firm view on the underlying asset's price at a future point in time. The lack of early exercise means that changes in interest rates or dividends do not create a dynamic exercise decision before maturity, simplifying some aspects of their analysis compared to other option types.

Hypothetical Example

Consider an investor, Sarah, who believes that Company XYZ's stock, currently trading at $100, will be above $110 in three months. She decides to buy a European style call option on XYZ with a strike price of $110 and an expiration date three months from now.

Purchase: Sarah pays an option premium of $3.00 per share for the call option. Each contract typically represents 100 shares, so she pays $300 for one contract.
Market Movement: Over the next three months, Company XYZ's stock price fluctuates.
Expiration: On the expiration date, XYZ stock is trading at $115.
Exercise: Since the stock price ($115) is above her strike price ($110), the option is "in the money." Sarah exercises her European style call option. She buys 100 shares of XYZ at $110 per share.
Profit Calculation: Sarah can immediately sell the shares in the market at $115.
- Proceeds from selling shares: $115 * 100 = $11,500
- Cost of exercising option: $110 * 100 = $11,000
- Initial premium paid: $300
- Net Profit = $11,500 - $11,000 - $300 = $200

If, on the expiration date, the stock price had been $108, the option would have expired worthless, and Sarah would have lost her $300 premium.

Practical Applications

European style options are integral to various investment and risk management strategies in global financial markets. Their exercise restriction simplifies their valuation and makes them particularly suitable for certain applications.

Hedging Price Risk: Investors can use European style put options to protect against potential declines in the value of a stock portfolio. For example, owning a European put allows a portfolio manager to lock in a minimum selling price for their holdings on a specific future date, providing downside protection.
Income Generation: Strategies like covered calls, where an investor sells a European call option against shares they already own, can generate income through the collection of the option premium.
Speculative Trading: Traders who anticipate a significant price movement in an underlying asset by a specific future date might use European style options for speculation. Their defined expiry and exercise provide a clear risk/reward profile at maturity.
Derivatives Market: European style options are commonly traded in organized exchanges globally. Regulatory bodies, such as the Financial Industry Regulatory Authority (FINRA), provide comprehensive disclosures on the characteristics and risks of trading standardized options to help investors understand these complex instruments., ¹⁰T⁹he Federal Reserve also monitors activities in the broader derivatives markets, including over-the-counter options, to assess financial stability.,
⁸
⁷## Limitations and Criticisms

While widely used, European style options, and particularly the Black-Scholes model used to price them, have several limitations. One primary criticism of the Black-Scholes model is its underlying assumptions, many of which do not perfectly reflect real-world market conditions. For instance, the model assumes constant volatility and a constant risk-free interest rate over the option's life, which are rarely true in dynamic markets., ⁶I⁵t also assumes that the underlying asset pays no dividends or that dividends are continuously paid and known, which can impact options pricing on dividend-paying stocks.

⁴Furthermore, the model assumes that returns of the underlying asset follow a log-normal distribution, which means it doesn't account for "fat tails" or "volatility smiles" observed in market data, where extreme price movements occur more frequently than predicted by a normal distribution., ³T²hese deviations can lead to mispricing, especially for options far out of the money or with very short maturities. While various modifications and alternative models have been developed to address these limitations, the fundamental Black-Scholes framework, and by extension, the theoretical valuation of European style options, remains subject to these inherent assumptions.

¹## European Style Options vs. American Style Options

The fundamental difference between European style options and American style options lies in their exercise flexibility.

European Style Options: These options can only be exercised on their specified expiration date. Regardless of how favorable the underlying asset's price movement might be before maturity, the holder cannot realize the option's intrinsic value by exercising it early. This characteristic makes them simpler to value mathematically, as the decision to exercise only occurs at one point in time.
American Style Options: In contrast, American style options grant the holder the right to exercise the option at any time between the purchase date and the expiration date. This flexibility provides an additional degree of freedom to the option holder. For example, if a company announces a large dividend payment, an American style call option holder might choose to exercise early to capture the dividend, a move not possible with a European style option. This early exercise feature adds complexity to their valuation, as the optimal exercise time must be considered. Due to the added flexibility, American style options are generally valued at or above the price of an equivalent European style option, all else being equal.

FAQs

Q: Can I sell a European style option before its expiration date?
A: Yes, while you cannot exercise a European style option before its expiration date, you can sell it on the open market if there is sufficient liquidity. The price you receive will reflect its current intrinsic and time value.

Q: Are European style options only traded in Europe?
A: No, the "European style" refers to the exercise feature (at maturity only), not the geographical location of trading. European style options are traded globally on various exchanges, including those in the United States.

Q: Why would someone choose a European style option over an American style option?
A: European style options are often simpler to understand and value, making them attractive for certain strategies, especially those where the primary concern is the price of the underlying asset at a specific future point. They are also sometimes less expensive than their American style counterparts due to the lack of early exercise flexibility.

Q: How does volatility affect the price of European style options?
A: Higher expected volatility of the underlying asset generally increases the value of both European style call options and put options. This is because greater volatility increases the probability that the option will expire "in the money" (i.e., the price will move significantly beyond the strike price).