Let’s take a look today at the difference between American and European options and where these names originated.
The origin of the names American and European options isn’t entirely clear, but the available explanations are quite interesting.
Both terms were allegedly first used by Paul A. Samuelson in his 1965 paper “Rational Theory of Warrant Pricing.” A later paper by Robert Jarrow and Philip Protter from 2004 attempts to explain how Samuelson came up with these names:
"This paper first introduced the terms “European” and “American” options. According to private communication with R.C. Merton, before writing the paper, P. Samuelson visited Wall Street to discuss options with industry professionals. His contact on Wall Street explained that there were two types of options available: one more complex, which could be exercised at any time before expiration, and one simpler, which could only be exercised on the expiration date. He added that only the more sophisticated European mind (as opposed to the American mind) could grasp the former. In response, when Samuelson wrote the paper, he used these names and reversed their order."
Even though this explanation sounds like a joke and there may have been other reasons, the story was also told by Paul Samuelson himself in an interview he gave to the American Finance Association in 2004:
... When I was talking to another one of those guys…
He said: I don’t understand why you’re here, what are you trying to do?
I replied: I’m trying to study the science of option pricing.
He said: That’s hopeless. You’ll never succeed.
And I asked: Why not?
He replied that it requires a European type of mind…
So, as revenge, I decided to name the simpler option the European option.
An alternative explanation is provided by Geoffrey Poitras, referencing Henry C. Emery’s 1896 book:
Although original historical sources are rare and unique, it is likely that trading in privileged rights in the USA was present from the early 18th century, from the beginnings of securities trading, possibly even earlier in commodity markets.
Over time, this rights trading developed differently from Europe due to different settlement practices.
In the USA, settlement for transactions from the previous day occurs every day… This is a significant difference from European practice, where trading involves a monthly or fortnightly settlement period with the possibility of carrying the position forward to the next settlement date (Emery 1896, p. 82).
Since the subsequent process, where the buyer wants to defer assignment, involves the immediate sale of the acquired shares and a simultaneous immediate purchase for the next settlement date, which would involve borrowing money, an additional “contango” payment was usually required.
As a consequence of these differences in settlement, in the USA (American) options evolved with fixed settlement prices, the possibility of settlement before the expiration date, and upfront payment of fees.
In Europe, fees for (European) options were due on the scheduled future expiration date, settlement could only occur on the expiration date, and the assignment price was adjusted according to the market price at the time of purchase.
It is unclear whether Samuelson was familiar with this text or whether it played a role in his use of these terms.
EUROPEAN OPTIONS
For European options, the holder can exercise their right, i.e., buy or sell the underlying asset under predetermined conditions, only on the expiration date of the option. This means that the option can be exercised at a fixed, specific point in time, namely on the last day of expiration, specifically after the close of trading on the expiration date of the option.
AMERICAN OPTIONS
On the other hand, the American option type allows the holder to exercise their right to buy or sell the underlying asset at any time from the purchase of the option until the expiration date.
Thus, the holder of this type of option has greater flexibility in trading, but as is often the case, there are pros and cons.
All options are either American or European style.
The name of the option, therefore, has nothing to do with geographical location, the location of the issuing exchange, or anything similar. All traded options are either European or American style.
HOW TO IDENTIFY WHAT TYPE OF OPTION IT IS?
All options on stocks and ETFs are American style. This also applies to most stock options traded in Europe, Australia, India, China, and most other major markets. A notable exception is Japan, where stock and ETF options are European style.
Most exchange-traded index options are also European style. However, there are exceptions here as well. Options on the OEX S&P 100 index are American style, while options on the SPX S&P 500 index are European style.
Options on the VIX fear index are European style.
Similarly, most futures options issued by the CME Group are European style.
Every trading platform that allows options trading should have a tool that lets you determine the specific type of option. Alternatively, you can look up the specification for a particular option on the issuer’s website.
In this image, you can see an example from the TWS Interactive Brokers trading platform with detailed information about an options contract, highlighting the method of option exercise. In this particular example, it’s an option on Crowdstrike stock with the ticker CRWD, along with other fundamental information on the right side of the window.
WHY IS IT USEFUL TO KNOW THIS?
First and foremost, it’s important to know for the trade you intend to make. For example, if you’re speculating on a decrease in volatility, you’ll definitely want to close the trade whenever it suits you.
This also applies if the market moves against you and you don’t want to be assigned; instead, you’d prefer to take a controlled loss and close the position immediately rather than with a much larger loss at expiration.
Written American-style options carry the risk of early assignment by the counterparty at any time during the option’s validity before its expiration. This risk increases before the so-called ex-dividend date, which is crucial for dividend payment eligibility for stockholders. If you hold a written CALL option that is ITM (In The Money, meaning the option’s strike price, e.g., 90, is below the current market value of the stock, e.g., 120), you risk being assigned 100 short shares at a price of $90. The counterparty will thus acquire 100 shares at $90, immediately gaining $3,000 on the shares, while your position will be $3,000 in the red. You would have to cover the position at the current market price. As the price continues to rise, your position will logically worsen.
Early assignment on a written option theoretically poses a risk at any time if you have an ITM option, and this situation may not be comfortable for some investors. For this reason, they may choose to trade European-style options, where they know that nothing will happen with the option without their knowledge until expiration.
An American-style option, compared to a European-style option on the same underlying asset, strike price, and expiration, will always have a higher premium due to its greater flexibility...
Another reason for using European options is the so-called cash settlement of options, meaning the option is settled in cash on the expiration date rather than in the form of shares. (In this context, “cash” means a non-cash transfer to your account with the broker. Here, “cash” does not refer to actual cash, but rather the term used to describe the amount of uninvested funds in your trading account with the broker).
With American options, you theoretically face the risk that the option price, just before the market close on the expiration day, might end a few cents OTM (Out of the Money), but in the subsequent aftermarket trading, to which you as a retail trader do not have access, the price of the underlying asset could move against you, causing the option to end up ITM. As a result, it would be automatically settled, and you would be either short or long on the shares, depending on the option you held.
With cash-settled options, this risk does not exist, because by the time of expiration, the option no longer had any time value, and cash settlement will have the same impact on your account as the option’s value before the market close on the expiration day.
A large portion of European options are cash settled, or conversely, if you’re looking for cash-settled options, the vast majority will be of the European type, meaning you must plan to trade and hold the option until its expiration.
Both types of options have their advantages and disadvantages, but American-style options are generally used much more frequently.
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