Alex has been dissatisfied with his job for a long time. After 17 years of committed loyalty to thecompany, waiting for conditions to improve and trusting that management would eventually dothe right thing to correct numerous problems, Alex has resigned. According to the “exit-voice-loyalty-neglect” model, Alex’s actions are examples ofloyalty and exit.
American and European options have similar characteristics but the differences are important. For instance, owners of American-style options may exercise at any time before the option expires. On the other hand, European-style options may exercise only at expiration. Although most equity options are American style options, many broad-based equity indices, including the S&P 500, have actively traded European-style options.
Options are contracts that derive their value from an underlying asset or investment. Options give the owner the right to buy or sell the underlying asset (such as a stock), at a fixed price (called the strike price), on or before a specific expiration date in the future. A call option gives the owner the right to buy a stock, for example, while a put option gives the owner the right to sell the stock. The up-front fee (called the premium) is what the investor pays to purchase the option. Typically, stock options are for a single stock, while index options are based on a basket of equities that can represent the equity market as a whole or a portion of the market, such as a specific industry. A stock option can be exercised before its expiration date (if it's American-style), while an option on an index can only be exercised on its expiry (if it's European-style). However, investors can unwind an option position by selling it before its expiry, including European-style options, though there could be a gain or loss between the premiums paid and received. All optionable stocks and exchange-traded funds (ETFs) have American-style options while only a few broad-based indices have American-style options. American index options cease trading at the close of business on the third Friday of the expiration month, with a few exceptions. For example, some options are quarterlies, which trade until the last trading day of the calendar quarter, while weeklies cease trading on Wednesday or Friday of the specified week. The settlement price is the official closing price for the expiration period, establishing which options are in the money and subject to auto-exercise. Any option that's in the money by one cent or more on the expiration date is automatically exercised unless the option owner specifically requests their broker not to exercise. The settlement price for the underlying asset (stock, ETF, or index) with American-style options is the regular closing price or the last trade before the market closes on the third Friday. After-hours trades do not count when determining the settlement price. With American-style options, there are seldom surprises. If the stock is trading at $40.12 a few minutes before the closing bell on expiration Friday, you can anticipate that 40 puts will expire worthlessly and that 40 calls will be in the money. If you have a short position in the 40 call and don't want to be hit with an exercise notice, you can repurchase those calls. The settlement price may change and 40 calls may move out of the money, but it's unlikely the value will change significantly in the last few minutes. European index options stop trading one day earlier, at the close of business on the Thursday preceding the third Friday of the expiration month. It is not as easy to identify the settlement price for European-style options. In fact, the settlement price is not published until hours after the market opens. The European settlement price is calculated as follows:
European-style options pose special risks for options traders, requiring careful planning to avoid systemic exposure. When you own an option, you control the right to exercise. Occasionally, it may be beneficial to exercise an option before it expires, to collect a dividend, for example, but it's seldom important. Dividends are cash payments paid to shareholders by companies as a reward to investors. When you sell an American-style option, you sell the option without owning it and are assigned an exercise notice before expiration and are short the stock. The only time an early assignment carries significant risk occurs with American-style cash-settled index options, suggesting the easiest way to avoid early-exercise risk is to avoid American options. If you receive an assignment notice, you must repurchase that option at the previous night's intrinsic value, placing you at serious risk if the market undergoes a significant move. It's advantageous to all parties when options are settled in cash:
These cash-settled options are almost always European-style and assignment only occurs at expiration, thus the option's cash value is determined by the settlement price. The settlement price is often a surprise with European-style options because, when the market opens for trading on the morning of the third Friday, a significant price change may occur from the previous night's close. This doesn't happen all the time but it happens often enough to turn the apparently low-risk strategy of holding the position overnight into a gamble. Here's the scenario faced by European option traders Thursday afternoon on the day before expiration:
When short the option, you face a different challenge:
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