A European option is a version of a contract that sets a limit on the rights to exercise until the day of expiration. In simpler words, when a trader’s security, such as a stock’s price, moves up, they would not be able to get these options to sell them further and make a profit. It will be possible only when the option has matured. As difficult as it sounds, let’s talk a bit more about how it works.
European Option in a nutshell
- European options can only be exercised at expiration.
- They are less flexible than American options.
- Common in currency, stock, and index markets.
- Two main types: Call options and Put options.
How are European Options defined?
A European option can be defined as the duration in which the holders of an important contract can use their contract rights for buying an asset or selling the asset according to the strike price. However, the option holder can only exercise the rights on these contracts on the day of the contract expiration, thanks to European options.
Premium Costs and Exercise Flexibility
However, for other option contracts, European options charge a premium cost for being exercised by the holder. Similarly, the American option is another type of options contract that should not be confused with the place of origin as it has nothing to do with it. Their premiums are even higher than European options.
Early Exit Opportunities
An investor may sell this contract to the market even before expiration and get the difference amount of earnings and initial pay even though investors do not get the choice of choosing the option.
Usually, European Index closes the business on a Thursday to allow the broker to price their assets according to the index according to their will. This gives birth to the settlement price, which is why investors see such drastic changes between Thursdays and Fridays.
Which types of European Options exist?
European options come in two main types: Call options and Put options.
- European Call Option: A contract allowing the holder to buy the underlying asset at a specified price upon expiration. Profit is made if the asset’s market price exceeds the strike price at expiry.
- European Put Option: A contract allowing the holder to sell the underlying asset at a specified price upon expiration. Profit is made if the asset’s market price is below the strike price at expiry.
What are the differences between American Options and European Options?
Unlike American options, European options can only be exercised at the expiration date, rather than at any time prior to expiration. This characteristic often results in European options being priced differently than their American counterparts due to the limitations on exercise timing. Below is a summary of the most important distinctions between European Options and American Options:
Feature | European Options | American Options |
---|---|---|
Exercise Time | Can only be exercised on the expiration date. | Can be exercised at any time between purchase and expiration dates. |
Flexibility | Limited flexibility, as exercise is only possible at expiry. | Offers flexibility, enabling exercise at any point before expiration. |
Dividend Consideration | Generally not suitable for dividend-paying stocks. | Ideal for dividend-paying stocks as they can be exercised before the ex-dividend date. |
Premium Cost | Typically, lower premium cost compared to American options. | Higher premium due to the added flexibility. |
Profit Realization Opportunity | Investors may miss out on profit if the stock moves in their favor before expiration. | Allows investors to realize profit as soon as the stock price moves in their favor. |
Example: How does a European Option work?
A European Option works by allowing the trader to realize a profit or loss only at expiration, as it cannot be exercised early. If the trader wishes to close the option position before it is expired, it means that the trader realizes that there is either loss or gain in the contract. Therefore, the trader could sell a call option if the stocks rise or sell the put option if the stock price falls, depending on the position of the contract. It all depends on the market conditions that prevail in the end, along with the premium that you paid at the onset. It also depends on the intrinsic value of the premium and the time value of the option, i.e., the time left before the contract has expired.
For instance, Citigroup is a bank whose stock price was down to $30 before the European Option had expired. As the stock price was below $50, the option was left with no meaning by the time of expiry.
Therefore, the investor lost the premium that he paid, which is around $500 for a European option contract. Now, the trader can either wait for expiration to see if the trade is profitable, or they can use the sell option. There is absolutely no guarantee that the premium that was received from the selling call option would be enough for the amount paid on the offset of the premium.
Can you trade Binary Options in the European Union?
No, binary options trading is not permitted in the European Union due to regulations set by the European Securities and Markets Authority (ESMA). However, individuals in Europe can still engage in binary options trading through offshore brokers, albeit with associated risks. These brokers act as intermediaries, facilitating binary options trading. Noteworthy options for European traders include Quotex, Pocket Options, and IQ Option.
Are Binary Options prohibited in the EU?
Yes, since 2018, the European Securities and Markets Authority (ESMA) has prohibited binary options trading for retail investors within the EU. This measure was implemented to safeguard retail investors from the risks associated with unregulated binary options trading.
Ban Extension and Continued Oversight
Since the implementation of the binary options ban by ESMA, the regulatory authority has extended its measures multiple times to ensure ongoing investor protection and market stability:
- The initial ban, effective from July 2nd, 2018, was extended until October 2nd, 2018.
- Subsequently, ESMA enforced a second ban extending from October to January 1st, 2019.
- The third ban came into effect in January and remained in place until April 1st, 2019.
- Furthermore, on February 18th, 2019, ESMA reaffirmed its commitment to safeguarding investors by maintaining the ban on binary options trading.
Note:
This material is not intended for viewers from EEA countries. Binary options are not promoted or sold to retail EEA traders. More info: https://www.esma.europa.eu/