European vs. American Style Options | Differences Explained
There are two main types of options: European style and American style. These types differ in how and when they can be exercised, as well as how they are taxed and valued.
In this article, we will explain the differences between European and American style options, their pros and cons, and which options belong to each type.
Key Takeaways
European and American options are two types of options contracts that have different characteristics and exercise rules.
European options can only be exercised on the expiration date, while American options can be exercised at any time before the expiration date.
What are European Style Options
A European option is a kind of contract that allows the holder to buy or sell an asset at a fixed price on a specific date. The holder does not have to exercise this right but can only do so on the expiration date.
Unlike American options, you cannot exercise European options before the expiration date.
Pros and Cons of European Style Options
Pros
No early assignment risk: Since you cannot exercise European options before the expiration date, you do not have to worry about being assigned shares of the underlying asset unexpectedly. This can reduce your margin requirements and avoid unwanted tax consequences.
Tax benefits: According to the 1256 tax code, any gain or loss from a section 1256 contract is treated as 60% long-term and 40% short-term capital gain or loss, regardless of the holding period1. This means that most European options are taxed at a lower rate than ordinary income, since long-term capital gains are generally taxed at a lower rate than short-term capital gains or ordinary income
Cons
Cannot exercise contract before the expiration: This can be both a pro and a con, depending on your perspective. On one hand, it can protect you from early assignment risk. On the other hand, it can limit your flexibility.
What are American Style Options
American options give the owner the right but not the obligation to buy or sell an underlying asset at a specific price at or before the expiration date.
American options can be exercised anytime before the expiration date, while you can only exercise European options on the expiration date.
Most single equities and ETFs have American options available, such as companies like AAPL and ETFs like SPY.
Pros and Cons of American Style Options
Pros
Ability to exercise before expiration: The ability to exercise your options early can be beneficial if you want to take advantage of a stock dividend or you simply want to convert your ITM option into shares before the expiration date.
Cons
Early assignment risk: Since American options can be exercised anytime before the expiration date, you also face the risk of being assigned shares of the underlying asset unexpectedly. This can happen if the option seller decides to exercise their option early or if the option is in-the-money and close to expiration. This can increase your margin requirements and trigger unwanted tax consequences.
Taxed as regular income: Depending on your country and tax situation, you may have to pay taxes on American options as regular income, regardless of whether you exercise them or not.
Key Differences Between European and American Style Options
The key differences between European and American style options include tax treatment and exercisability.
60% of European options profits are taxed at the long-term capital gains rate, while American options are taxed as regular income.
European options can only be exercised on the expiration date, while American options can be exercised anytime before the expiration date.
Additionally, some options strategies may work differently for European and American options.
Box spreads, for example, are risk-free for European options since they can’t be assigned early. However, if you trade box spreads on American options, then you have risk potential. You can read about a Robinhood trader who leveraged his account in box spreads with American options and lost a lot of money.
Robinhood doesn’t allow you to trade European style options. Luckily, brokerages built for options traders like tastytrade do. You can see our comparison of tastytrade and Robinhood for more information.
Which Options are European Style?
European style options are available on major stock market indices like SPX (S&P 500 Index), NDX (Nasdaq 100 Index), RUT (Russell 2000 Index), and most futures options.
These options are cash-settled, meaning that no shares of the underlying asset are exchanged when they are exercised. Instead, the option buyer receives or pays the difference between the strike price and the settlement price of the underlying asset in cash.
Which Options are American Style?
American style options are available on most publicly traded equities and ETFs such as SPY (SPDR S&P 500 ETF), AAPL (Apple Inc.), QQQ (Invesco QQQ Trust), and many more.
These options are physically settled, meaning that shares of the underlying asset are exchanged when they are exercised. The option buyer receives or delivers the shares of the underlying asset at the strike price.
How to Learn More About Options Trading
Options trading can be a powerful tool for hedging your risks, speculating on price movements, or generating income from your holdings. However, it can also be complex and risky if you do not understand how options work and how to use them properly.
If you want to learn more about trading options, you can join the HaiKhuu Trading Community.
HaiKhuu offers daily morning reports, live trading calls, and access to a community of like-minded traders willing to help you in your trading journey.
Whether you trade European or American style options, you need to have a clear strategy, a solid risk management plan, and a reliable trading platform, such as tastytrade.
Tastytrade Disclosure
tastytrade, Inc. (“tastytrade”) has entered into a Marketing Agreement with Marketing Agent (“HaiKhuu LLC.”) whereby tastytrade pays compensation to HaiKhuu LLC. to recommend tastytrade’s brokerage services. The existence of this Marketing Agreement should not be deemed as an endorsement or recommendation of HaiKhuu LLC. by tastytrade and/or any of its affiliated companies. Neither tastytrade nor any of its affiliated companies is responsible for the privacy practices of HaiKhuu LLC. or this website. tastytrade does not warrant the accuracy or content of the products or services offered by HaiKhuu LLC. or this website. HaiKhuu LLC. is independent and is not an affiliate of tastytrade.
tastytrade was previously known as tastyworks, Inc.
