One aspect of trading options that is overlooked is style risk. Style risk does not refer to the risk that you may trade according to some outdated trend but rather the fact that options have their own style. The style of an option will affect the way that the option is exercised. Style risk also impacts upon the end of trading for that option. Being unaware of an options style can create multiple risks for traders.
There are two styles for options in the U.S. Markets. These are American style and European style. American style options can be exercised at any point up to the cut-off date. With European style options the the option can only be exercised on a specific designated date. The style of an option can be found by looking at the options product specification sheet. This is available from he Options Clearing Corporation(OCC).
In general if the option is derived from an index then it will be an European style option. If you have purchased a European option you will only be able to exercise it on the specific exercise date. This contrasts with the American style option which can be exercised on any day leading up to the expiration date. The exact exercise date will depend on what type of index the option derives its value from. Because of this you must handle European options carefully, and you will want to find out what the exercise date for the option is from its product specification sheet. European options have three key dates that you will want to be aware of. These are:
- The Last Trading Date As the name suggests this is the last day that the option can be traded on. Unlike American style options this maybe up to two before the exercise date. This is one of the reasons that taking note of an options style is so important. If you don’t realise that the option is a European style option you may find yourself holding a position that you can’t trade out of.
- The Settlement Date This will be a specific date and time which indicates at what point the index will be measured to determine its value at expiration. Again this does not need to be the exercise date so you will want to make careful note of this information.
- Exercise Date On the exercise date the long holder of the option can exercise their rights.
If the underlying value of the option is derived from stock in general the option will be American style. American style options have the following characteristics.
- Once the option has been bought it can be exercised by that holder at any time during the contracts life.
- If you are selling the option you can buy-to-close the option on the last day of trading at any point prior to the close.
- The option itself will trade from the point that it is initiated until the last day of day trading prior to its expiration.
Make sure that before you purchase an option you are aware of what style it is. If the option is European style you will want to make careful note of the three key dates when planning your trading strategy.