European Options

What is a European option?

A European option is a type of options contract that can be exercised only on its expiration date. It grants the holder the right, but not the obligation, to buy (call) or sell (put) the underlying asset at a predetermined price (the strike) on that single day. The buyer pays an upfront cost known as the premium.

Most index options are European-style because they simplify accounting and settlement for brokers. European options are often valued with models such as Black–Scholes and commonly trade over-the-counter (OTC), while many American-style options trade on standardized exchanges.

Key takeaways

• Exercise is allowed only on the expiration date, not before.
• Because of limited exercise flexibility, European options generally command lower premiums than comparable American options.
• Holders can still sell (close) the contract before expiration to realize gains or limit losses.
• Black–Scholes is a standard model used to price European options.
• Many index options are European; settlement timing can cause surprises when underlying prices move between the last trade and final settlement.

How European options work

A European option specifies:
* Strike price — the fixed price at which the underlying is bought (call) or sold (put) if exercised.
* Expiration date — the only date on which the option can be exercised.
* Premium — the cost paid to acquire the option.

The option’s market value between purchase and expiration depends on:
* Intrinsic value — the immediate exercise value (if any) relative to the strike.
* Time value — the value attributable to remaining time until expiration.
* Volatility and movements of the underlying asset.

Although exercise is restricted, holders typically close positions by selling the option in the market before expiration if they wish to realize profits or cut losses.

Types: Calls and Puts

• Call (European call): Right to buy the underlying at the strike on expiration. Profitable if the underlying price at expiration exceeds the strike plus the premium paid.
• Put (European put): Right to sell the underlying at the strike on expiration. Profitable if the underlying price at expiration is sufficiently below the strike to offset the premium.

Closing a European option before expiry

Exercising is not the only way to exit a position. Most traders sell the option contract before expiration if:
* The option premium has risen above what they paid (realize profit).
* Market conditions, volatility, or time decay make further holding unattractive.

When selling early, the trader captures the difference between the sale price and the original premium, reflecting both intrinsic and remaining time value. Near expiration, time value is minimal, so early sale proceeds are typically close to intrinsic value.

Differences from American options

• Exercise timing: European — only at expiration; American — any time before and including expiration.
• Early exercise: American options permit early exercise (useful for dividend capture), European do not.
• Premiums: American options are generally more expensive due to greater flexibility.
• Trading venue: European options often trade OTC; American options are commonly exchange-traded.

Because American options allow early exercise, they can be preferable with dividend-paying stocks; however, that flexibility increases cost.

Valuation and settlement notes

• Pricing models: The Black–Scholes model is widely used to price European options because its assumptions align with the single-exercise feature.
• Index settlement: Many European index options stop trading at the close of business on the Thursday before the third Friday of the expiration month. Final settlement prices may be established after markets reopen on Friday, which can lead to unexpected settlement outcomes if underlying component prices move in the interim.

Pros and cons

Pros
* Lower premium cost vs. American options.
* Standard structure for many index contracts.
* Can be sold before expiration to capture gains or limit losses.

Cons
* Cannot be exercised before expiration (no early exercise for dividends or other events).
* Settlement timing for some index options can delay and complicate final pricing.
* Often OTC, which may involve different liquidity and counterparty considerations compared with exchange-listed options.

Example

An investor buys a European call on a stock with:
* Strike: $50
* Premium: $5 per share
* Contract size: 100 shares (premium cost = $500)

If the stock trades at $75 at expiration:
* Gross profit on exercise = $75 − $50 = $25 per share
* Net profit = $25 − $5 = $20 per share → $2,000 total

If the stock trades at $30 at expiration:
* Option expires worthless and the investor loses the $500 premium.

The investor could alternatively try to sell the call before expiration; whether the sale recoups the original premium depends on time remaining, volatility, and underlying price movements.