European option vs American option

Disclaimer: Options trading is considered extremely risky, 9 out of 10 traders incur a net loss, please trade responsibly. See the SEBI circular for more details

Options are of two different types based on how they can be exercised and when they can be exercised.

What does it mean to “exercise option”

Every option is a contract to buy or sell shares at a pre-determined price, the contract gives the buyer an option to buy or sell but no obligations. For example, If I buy a Put option for a share, I can sell the shares at the strike price to the seller if I wish to, but I do not have an obligation to sell my shares. So it would only make sense for me to sell my shares if I stand to gain. However, if I need to sell my shares, I would need to “exercise” my options right, thereby forcing the seller to buy the stocks which I have in my possession. If I do not have the shares and I exercise the option, I would need to buy the shares from the market and provide it to the seller.

If you are just starting with options, please read out a primer on options.

European style options

European style options can only be exercised on the expiration date and not before the expiration. This makes it much safer for the option seller since the seller does not need to have the funds or shares with them in case the buyer decides to exercise the options before the expiry date.

American style options

American style options are those types of options that can be exercised anytime before the expiration date. These style of options are riskier for the option seller since the seller need to maintain either shares or cash equivalent as the buyer can exercise the option anytime before the expiry. Since these options carry significantly higher risk, they carry higher “premiums”.

What kind of option does NSE have?

NSE options are usually European style options, typically European style options carry an E notation so Put would be denoted with PE while an American style Put would be denoted as PA. See how to identify American/European option.

This means the options can only be exercised on the expiry day and not before that.

How are options exercised?

Stock Options are considered exercised if they are not closed off before 3.30 PM on the day of expiry and the exchange would call on the seller to provide shares of the lot quantity and transfer it to the buyer.

While Index Options are cash-settled if they are not closed off by the end of expiry.

Should you exercise the options?

If you do decide to exercise the options you should have the shares in your trading account or cash equivalent. So let us assume if you exercise a PE of Infosys, you would need to sell 400 shares of Infosys, if you do not have 400 shares, you would need to buy 400 shares from the market and provide the exchange with those shares, which would mean you need to have cash worth 400 shares.

an ATM option of 1340 PE of Infosys is trading at a premium of 38, so a PE is going to cost you Rs 15200, however executing it would mean you need to have shares worth Rs 5,36,000 or equivalent cash and also you would be charged taxes by the exchange on 5,36,000 and not 15,200. see STT Trap.

You should always close off your position before expiry if you are trading in stock options, however since Index Options are cash settled, you can let them expire and equivalent cash would be sent to your trading account by exchange.






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