What is a European option?

  There are two types of securities granting the right to buy or sell an asset at a fixed price — American and European options. On stock exchanges, the American model of the document is used much more often, while the European one is popular in larger transactions.

 

What is a European option?

  An option is a security, an agreement between two parties, both private individuals and legal entities, to buy or sell an underlying asset at an agreed price in the future. The option seller cannot refuse the holder’s demand and therefore, at the beginning of the agreement, requires payment of a premium — a sum of money that balances the risks and income opportunities of both parties.

  The document has its own term during which the buyer may exercise this right. The expiration period ranges from several minutes to several months. The longer the term, the greater the seller’s risk. Accordingly, the size of the premium also increases, since it is always equivalent to the level of potential financial loss.

  In some cases, the buyer may demand early expiration, for example, if the asset price has reached the most favorable point.
  Early exercise of the rights granted by the contract is unprofitable for the seller. He finds himself in a difficult situation: he must quickly sell the asset or pay the buyer the amount that could have been obtained if further transactions were successful.
  In an option transaction between two large companies, early expiration may become a reason to terminate further cooperation.
  A European option excludes the possibility of exercising rights before the agreed term. Execution of the contract can occur only on the very last day of its validity or on the date agreed upon by both parties.
  Often, when concluding long-term transactions, several maturity dates are appointed during which the buyer may exercise the right. Essentially, this approach is the same early expiration, but with minimal risks for the seller of the security.

 

Legal aspect of European options

  Any option is a security, and therefore its execution must be controlled by the relevant authorities.
  Mainly, the control of conducted transactions and the provision of conditions for their proper execution are handled by stock and options markets. They operate in accordance with international rules and the legislation of the country in which they are located.
  The pioneer in the legal reinforcement of options is the London Stock Exchange, and the security type itself first appeared in Holland. That is why the Old World can confidently be called the birthplace of options, and the European option the very first model of their execution.

 

Use of European options

  European options have a wide range of applications:
  1) Earning profit from currency fluctuations.
  In this case, both types of securities can be used — put and call. The trader acquires them in the hope that in the near future the option price will change in his favor.
  For example, a currency transaction is concluded to buy the dollar at the exchange rate valid at the time of the contract, say 38 rubles per unit. The option term is 3 weeks, the premium size is 3% of the investment amount. After a week, the dollar rises sharply by 5%. Taking into account the option premium, the buyer’s profit will amount to 2%. He will buy from the option seller the required amount of dollars and then sell them at the market price.

  2) Hedging investments. Large traders rarely trade on the stock exchange without additional insurance of their investments. For this purpose, additional transactions are concluded that can cover losses from an unfavorable investment outcome; such a strategy is called hedging.

  As an example, let us take a put option, which gives its holder the right to sell the underlying asset at a fixed price. The trader owns a certain number of shares. He learns that in the near future a sharp collapse in the price of this asset is possible. In order to recover the funds spent on the shares, he enters into an option transaction in which the seller undertakes to buy the shares at the price valid at that moment. If the price collapse really occurs, the trader will simply sell his shares and lose only the small premium he paid to the seller.