American-Style and European-Style Options
So far, we've been discussing equity options that can be exercised at any time. But not all options work this way. The distinction between American-style and European-style exercise is one of the most commonly tested options concepts.
Comparison
| Feature | American-Style | European-Style |
|---|---|---|
| Exercise timing | Any business day up to and including expiration | Only at expiration |
| Common products | Equity options, ETF options | Index options (e.g., S&P 500, broad-based indexes) |
| Settlement method | Physical delivery of underlying shares | Cash settlement |
| Early exercise risk | Yes - writer can be assigned at any time | No - assignment only occurs at expiration |
Key points:
- Equity options are American-style: the holder can exercise at any time, and the writer faces assignment risk at any time
- Broad-based index options are European-style: no early exercise, and settlement is in cash (because you cannot physically deliver "an index")
- Narrow-based (industry/sector) index options may be either American-style or European-style depending on the product
Exam Tip: Gotchas
- "American" and "European" refer to exercise style, not geography. An option traded on a European exchange can still be American-style.
- European-style writers face no early assignment risk. Assignment can only occur at expiration, unlike American-style options where the writer can be assigned on any business day.
Cash Settlement for Index Options
When an index option is exercised, no shares change hands. Instead, the writer pays the holder the intrinsic value in cash:
Cash settlement amount = (Index level - Strike price) x Contract multiplier
- The standard contract multiplier for index options is $100
- Example: An investor exercises a long call on the XYZ Index with a strike of 1,500 and the index closes at 1,520
- Cash settlement = (1,520 - 1,500) x $100 = $2,000
Exam Tip: Gotchas
- Equity options settle by physical delivery of stock; index options settle in cash. If the question involves an index option, the answer is always cash settlement. If it involves a stock option, the answer is delivery of shares.