American and European Options

The most basic difference between an American option and a European option is that a European option may only be exercised on the expiration date, while an American option may be exercised at any point before that date. All options give the holder the option, but not the obligation, to buy (in the case of a call) or sell (in the case of a put).

All options on individual stocks are American style. Options on the major indexes (OEX is an exception) are European. Some examples of actively traded European style options:

SPX: Standard & Poor’s 500 Index
DJX: Dow Jones
Industrial Average
NDX: NASDAQ 100 Index
RUT: Russell 2000 (small cap) Index

Differences in Value

Typically, because an option’s value is based largely on the amount of time left until expiration, the holder of an option usually prefers to close the option position rather than exercise the option. There are rare instances, however, when the owner of an American option will prefer to exercise the option rather than close the position.

For example, just before the underlying stock pays a dividend, if the option’s value falls by more than the remaining value, it is advantageous to exercise the option. Because of the anomalous instances, calculating the value of an American option can be difficult.

Essentially, while a European option can be accurately valued using the famous Black-Scholes pricing model, American options require a more complex pricing model. What most traders need to understand is that an American option will always be worth at least what a European option is worth.

**Asian Options**

An Asian option (or average value option) is a special type of option contract. For Asian options the payoff is determined by the average underlying price over some pre-set period of time. This is different to the case of the usual European option and American option, where the payoff of the option contract depends on the price of the underlying instrument at maturity; Asian options are thus one of the basic forms of exotic options.

One advantage of Asian options is that these reduce the risk of market manipulation of the underlying instrument at maturity. Another advantage of Asian options involves the relative cost of Asian options compared to European or American options. Because of the averaging feature, Asian options reduce the volatility inherent in the option; therefore, Asian options are typically cheaper than European or American options. This can be an advantage for corporations that are subject to the FASB revised Statement No. 123, which requires that corporations expense employee stock options.