European style option

These type of financial options are only exercisable on the expiry date of the option itself and not anytime before that.

They are, of course, less valuable than American style options, as they are more limited.

morgdx's example is seriously flawed. The figures quoted are hardly real world figures.

For buying at the money options, it is highly unlikely that at the money American style options would be selling for ten times the price of the same strike price European style options. The other thing is that the absolute price quoted is dodgy - $100k to buy options over 1 million units for one year at a strike price at the money for a period of 12 months is way too cheap ... though not as underpriced as the same European options mentioned later.

It's not that easy to make that much money in the real world.

European options are less expensive than American style options, but no less valuable.

When options were young there was a huge premium on Americans because you could close out a profit at any time during the term of the instrument, this was until some bright spark realised that you could get exactly the same effect with two Europeans.

Consider the following example:

• Foobars are $10 each. My bad coding market analyst thinks that this price is going to rise.
• I buy an American style option to buy a million foobars at $10 each at any point over the next 12 months. This option costs me $100,000.
• After 6 months a major foobar factory in Bogota is destroyed in a freak landslide. (No one is seriously injured).
• World foobar production drops by 30%, and this, combined with the increase in the consumption of bad code means that the market rate for foobars is now $25.
• I decide to take a profit, and I exercise my option to buy a million foobars at 10$. Being a coder from the Berkeley tradition, I have no interest in foobars for myself, so I immediately sell the whole lot on for $25, netting myself an instant profit of $14.9M ($15*1M minus the 100k cost of the option).
• I retire to the beach, drink beer and write poetry.

Pretty smart, you might think, if I'd just bought a European option I wouldn't have been able to lock in my profit. I would have been chewing my finger nails to the bone as I watched the price of foobars sink to 9$ each at the end of the year. You would have laughed yourself hoarse at all things European.

But I am no ordinary European option trader, because I have the almost alchemic ability to turn European options into Americans, it goes a little like this:

• Foobars are $10 each. My bad coding market analyst thinks that this price is going to rise by this time next year.
• I buy a European style option to buy ten million foobars at $10 each in twelve months time. This option costs me $100,000 (remember, European's are much cheaper than Americans, but don't quote me on that).
• After 6 months a major foobar factory in Bogota is destroyed in a freak landslide. (No one is seriously injured).
• World foobar production drops by 30%, and this, combined with the increase in the consumption of bad code means that the market rate for foobars is now $25.
• I decide to take a profit, so I sell options so that someone else can buy ten million foobars from me at $10 each in six months time. This option is so far out of the money that I can sell it for $100M, netting myself an instant profit of $99.9M.
• If the price of foobars is over $10 at the end of six months I'll exercise my option to buy $10M worth of foobars and sell the foobars to the person who bought the option from me for $10M.
• I buy the beach, drink beer and write poetry.

We can see here that my exposure for both scenarios was $100,000, but because European options are cheaper I can get greater leverage from my investment.