American vs European vs Bermudan Options

Financial derivatives are contracts tied to a particular financial instrument, indicator, or commodity and allow for the independent trading of specific financial risks on trading markets. 

An option is a financial instrument based on the value of underlying security like a stock.

Depending on the type of contract, options give the buyer a choice to purchase or sell at the agreed-upon price, regardless of the market price. 

These contracts give purchasers a choice, but not the obligation, to buy or sell an underlying asset at a predetermined price unless they were contract writers (sellers).

Numerous techniques for hedging, earning money, or speculating are built on calls and puts.

Investors should carefully consider the risks, even though there are infinite possibilities to earn high profits.

They come in several varieties with varying constraints on exercising. American, European, and Bermudan alternatives make up the three fundamental categories. 

Examining American, European, and Bermudan alternatives will help us understand how they differ. Although they all share some traits, the variances are crucial. 

For example, owners of an American-style contract may exercise their rights at any moment before it expires. European-style, however, may only be exercised at expiry.

Additionally, Investors can purchase or sell a security or underlying asset at a predetermined price on a series of defined dates, as well as the expiration date, using Bermudan options.

Spreads are strategies that combine buying and selling several options to achieve the appropriate risk-return profile. Spreads can profit from various conditions, including high or low volatility situations, up or down moves, and everything in between.

American Options

These are the most well-known and commonly-utilized financial derivatives. They come in call and put varieties. The standard expiration for stock options in US stock exchanges is three months to one year.

Because American-style contracts have the most flexible exercise schedule and may be exercised at any time before expiry, they are often employed.

Only a few broad-based indexes contain American-style, although all equities and exchange-traded funds (ETFs) do.

With a few exceptions, they stop trading at the close of business on the third Friday of the expiry month. Weeklies expire on the Wednesday or Friday of the given week, although other options, known as quarterlies, continue to trade until the last trading day of the applicable calendar quarter.

The strike price is the cost at which the holder may purchase or sell the underlying securities, thus exercising the option.

Premium is the price paid by the buyer of the contract to the one shorting it (writer). It is the price to buy the rights for an option. 

In a call, the contract is in the money when the market price is higher than the strike price, regardless of the premium price, and out-the-money when it is less. For a put, it is the exact opposite.

As one might anticipate, "at the money" refers to a contract when the strike price and the underlying stock price are identical.

However, the investments only start making a profit when it exceeds the cost of the contract (premium).

Call Example

Let us examine a case. An investor who bought a March American call option knows it will expire in July. It states that he can buy shares of Company XYZ stock for $10 each. 

The trader notices that the stock's price is rising steadily. By the end of March, the stock price had increased to $20. So he exercises his option and spends $1,000 to buy 100 shares of stock (the most common amount of shares an opportunity will represent) at the $10 strike price.

Following that, he sells his shares at the going rate and makes $2,000 ($100 shares x $20 per share) from the transaction. Because he could sell his shares for double what he paid, he has made a profit of $1,000, excluding the premium.

Put Example

After conducting some analyses, let us assume you concluded that the price of XYZ Firm's shares would fall below $100 per share. Therefore, you purchase the right to sell 100 shares at $100 per share by acquiring a put for $10.

If the company's price falls to $75, you might exercise it and sell 100 shares for $100 each, making $1,500 overall. That is the $25 profit multiplied by 100 shares, less the $10 premium (bred by 100).

You might decide to sell the contract to another buyer if you do not already possess 100 shares of the stock; this activity is more often referred to as options trading.

European Options

The unique feature of European-style contracts is that they cannot be exercised before expiration. As a result, traders have significantly less freedom in approaching this type of trading because they can only execute on a single date. 

As a result, they are frequently valued lower than their American-style counterparts and may, thus, be bought at a lower price. European-style contracts are often traded over-the-counter (OTC) rather than on an exchange is another distinction between them and the American and Bermuda styles. 

It is crucial to remember that, although their traders have restrictions on when they can exercise, they are still allowed to sell them to another trader in the secondary market before it expires.

The European index options market closes one day early, the Thursday before the third Friday of the expiry month.

For European-style contracts based on indices, it is more difficult to determine the settlement price. The settlement price is not generally announced until many hours after the market has opened.

It is assumed that all equities would be trading at their respective opening prices simultaneously to determine the underlying index's price. Because you cannot infer the settlement price's value from the published index, this price does not represent the market's actual value.

Example

An investor purchased a European call option with a strike price of $50 and an expiration date in July (on 100 shares of Company XYZ). 

By May, he saw that the shares would reach $75, but even though the investment is at the money, he can only exercise it at expiration and is not free to do so now.

Unfortunately, the price of XYZ stock dropped to $45 per share by the time the expiration or maturity date arrived. As a result, he won't exercise the contract, as it will create a loss, but he will forfeit the premium he paid to purchase it.

Payment in Cash

When options are settled in cash, both sides benefit:

1. There is no transfer of shares.
2. You do not lose active positions if given an exercise notice on calls you wrote, like in covered call writing or a collar strategy, so you don't have to worry about reconstructing a complicated stock portfolio.
3. The cash value of the option is paid to the seller, and the contract is given to the owner. That cash value is the same as the intrinsic value of the vote. It expires worthless and has no financial value if it is out of money. If it passes in the capital, the seller will pay the owner the difference between the market and strike price.

Bermudan Options

Bermuda-style contracts are a special kind of exotic options contract that may only be executed on specific days, usually one month. 

Investors have the opportunity to design and buy a hybrid contract. In other words, investors are given more flexibility when it can be exercised.

The premiums for Bermuda-style contracts are often less expensive than those for American alternatives. However, the Bermuda option pricing is usually comparable to that of their American and European equivalents.

Put another way; they designate particular dates before expiration on which the trader may exercise their option. Typically, the dates for the specified exercises fall close to the expiration date. 

Bermudan options sit between American and European regarding the degree of flexibility a trader has when exercising them.

Example

Imagine a trader buying a call option with expiration in July for 100 shares of Company XYZ. At $50 per share, a trader with a Bermudan call option can decide to purchase shares of Company ABC.

The only restriction is that, according to the terms of the option contract, he may only exercise it on four specific dates in July. The amount of exercise freedom he enjoys is more significant than it would be with a European contract, but it is still far less than it would be with an American option.

Researched and authored by Chadi Kattoua | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Box Spread
• Candlestick Patterns
• Nifty 50 Index
• Out of the Money (OOTM)
• Over-Trading