Bryan Perry

A 'World' of Different Option Exercise Types

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So, if you bought the Dow Jones Industrial Average (DJI) October 129 Calls, you could only exercise them on their mid-October expiration date. But if you instead held calls on a Dow component stock -- such as American Express (AXP) -- you could exercise them during any day that the market is open.

However, no matter what the option's exercise style is, you can choose to close your option trade at any time without exercising the right (but not the obligation) that comes with it.

Of course, while European options can never be exercised early, American options are rarely exercised early. This stems from an option's non-negative time value, which means options are usually worth more unexercised -- this is especially true when traders write (or sell to open) option trades and with credit spreads (in which a trader sells a higher-cost option and buys a lower-cost option in the same underlying instrument, which allows them to initiate a lower-risk trade in which they can collect the trade's full value upfront).

When examining the differences between American and European options, valuation also comes into play. European options are typically valued using a simple equation that has become standard among analysts, called the Black-Scholes, or the Black model, formula. Valuation for American options again plays to the theme of "freedom to choose," as they are valued using a host of models to approximate the price, and there is no "standard" option pricing model.

For investors, this means that with otherwise-identical American and European options (that is, with the same strike price, expiration date, etcetera), the American option will be worth at least as much as the European. If it is worth more, then the difference can predict the likelihood of early exercise.

Because American-style options can typically have higher value and offer more choices, they are the most popular style of options. But, if neither American nor European options are what you're after, there is also Asian-style options exercise. They're also called "average options," and their payoff relates to the average value of the underlying stock on a specific set of dates during the life of the option trade. However, their exercise is usually European in style.

With all of the emphasis on globalization, options traders might be tempted to try the different options styles. But for the newer options trader, this is one time when being "domestically inclined" could likely be more profitable.