Derivatives

Options: European is what you have, American is what you prefer

Venkatesh Bangaruswamy | Updated on August 01, 2021

Amount of time given to exercise options is a key differentiator

We have so far discussed various equity derivatives trading strategies in this column. This week, we look at how an exercise style can impact option trading.

European vs. American

There are typically two styles of exercise in exchange-traded equity options. European options offer you the right to exercise only at expiry. American options give you the right to exercise anytime during the life of the option and at expiry. This suggests that American options are better than European options.

Of course, you do not get to choose the exercise style in the market. The exchange where you trade options will offer either American or European style. The NSE currently offers European style options.

Traders typically do not buy options to exercise their right to buy the underlying. Their objective is to sell the option at a higher price as quickly as possible. The reason is simple. The option premium or the option price is a cost. So, if you buy the 2000 strike call option on Reliance Industries for 90 points, your total cost of buying the shares, in the event you exercise the option, will be 2090. You might as well buy the shares in the spot market without incurring the additional cost. The logic is the same for puts.

So, if option traders do not exercise the option, it may appear that exercise style does not matter; if a trader wants to sell the option that she bought earlier, she can do so whether the option is American or a European style.

As it turns out, exercise style does impact options trading. How? Suppose you buy the 15700 strike call on the Nifty index when the underlying trades at 15710. Assume the underlying increases by 200 points. Your option will now be in-the-money (ITM); it would have gained 200 points of intrinsic value but would have lost some time value due to time decay.

The issue is that trading will now be concentrated on the 15900 and 16000 strike calls because the 15700 call, being ITM, would have significantly increased in price. That means you may be unable to sell your call. You must wait till expiry to exercise the option and capture your profits. But the index can decline just as quickly as it went up and wipe out the unrealised gains on the option. In a similar situation, you could have exercised an American option.

To manage this risk in European options, you should actively shift your strike as the underlying changes. So, if you buy a Nifty ATM call option, you should sell the option when the underlying moves close to one tradable strike from the option you hold. Note that we refer to tradable strike because strikes ending in 50s on the Nifty Index are not actively traded. So, if you hold the 15700 strike, then you should consider selling the option if the underlying moves towards 15800. You can buy the current ATM strike (15800) if you want to continue your long position. You may have to similarly adjust your option position on any underlying based on the strike intervals offered by the NSE.

Optional reading

You capture both the intrinsic value and the time value when you sell an option. But you can get only the intrinsic value when you exercise the option. This makes it optimal to sell the option in the market, not exercise it. There are, however, exceptions to this argument.

As already discussed, you should exercise when you have sizeable unrealized gains on the ITM strike before the option sheds these gains. Other exceptions include the desire to capture corporate actions on the underlying, such as cash dividends and bonus shares (or stock dividends). The above discussion suggests that American options can be useful, even if a trader’s primary intention is not to exercise the option.

The author offers training programmes for individuals to manage their personal investments

Published on July 31, 2021

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