An option style refers to whether the option contract can be exercised before the expiration date or not. European options cannot be exercised before the expiration date of the option contract. American options can be exercised by the option holder (the option buyer) any time during the life of the contract.
American-style options are options that can be exercised at the strike price anytime before or on the date of expiration. European-style options, on the other hand, are options that can only be exercised at the time of expiration.
All other things being equal, American-style stock options tend to cost more than equivalent European-style options for the same stock. The reason for this is that an American-style option gives its holder more opportunity to use the option and, therefore, a holder pays more for that privilege.
Nearly all exchange traded stock options, such as those issued for companies like Microsoft and Sony, are American-style options. Interestingly enough, financial index options can be issued as either American- or European-style options.
The key difference between American and European options relates to when the options can be exercised:
- A European option may be exercised only at the expiry date of the option, i.e. at a single pre-defined point in time.
- An American option on the other hand may be exercised at any time before the expiry date.
Difference in value
European options are typically valued using the Black Model formula. This is a simple equation with a closed-form solution that has become standard in the financial community. There are no general formulae for American options, but a choice of models to approximate the price are available.
Where an American and a European option are otherwise identical (having the same strike price, etc.), the American option will be worth at least as much as the European (which it entails). If it is worth more, then the difference is a guide to the likelihood of early exercise.