An option style refers to whether the option contract can be exercised before the expiration date or not.
European options cannot be exercised before the expiration date of the option contract. American options can be exercised by the option holder (the option buyer) any time during the life of the contract.
For example, say you have an option contract that expires in six months, however, after two months it is already showing a large unrealized profit.
In this case you might not want to risk waiting until expiration to take profit on the contract. The market might actually start trading against you and the position might lose it's value. Of course you could always simply reverse the position by trading out of the contract in the market to capture the profit. But there are situations where you may really want to take delivery of the underlying asset. In this case you may decide to exercise the option and take delivery of the stock.
Option contracts that do not permit early exercise i.e. European Options, are most commonly the style of option used by indices i.e. the S&P 500. American options are the style of choice for most stock options.
For example, let's say you are long (i.e. you bought) a call option that has doubled in profit after a couple of days. If the contract stated an American style you could exercise the option now and take delivery of the stock (underlying) at the exercise price and double your profit.
If the contract stated European style, you cannot exercise until the expiry date of the contract. You could of course sell the option contract back on the option market and still realize your profit without taking delivery of the contract.
The main difference between the two is how the options are priced - i.e. how you determine the theoretical price of the contract. Don't worry too much about the pricing for now - there is more of that under the pricing link.
Comments (2)
sanjeev
September 5th, 2011 at 6:39am
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shesha1970
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