An European option is a type of financial contract that allows the holder to exercise its right only on a specific date: the date on which the contract expires. This feature distinguishes European options from American options, which offer greater time flexibility. Available in call and put versions, European options are on the Italian IDEM market and include underlyings such as the FTSE MIB index and some stocks of companies listed on Italian stock markets.
The limitation on early exercise means that these options generally have a lower value than American options with similar characteristics, thus offering a different type of strategy to investors.
European options are an attractive choice for investors who prefer defined strategies that are less influenced by market fluctuations.
Due to their structure, these options offer control over minimum and maximum values, thus avoiding arbitrage risks and ensuring fair value at all times.
Value of European options: between upper and lower bounds
The value of an European option must always be between a lower and an upper limit to avoid arbitrage possibilities, that is, certain gains without risk.
In the case of European call options, the lower limit of value is determined by the difference between the present value of the underlying asset and the discounted value of the strike price, that is, the amount that would have to be invested today to reach the strike value at the end of the contract.
For European put options, the upper limit of value corresponds to the discounted value of the strike price, i.e., the amount the holder would receive at expiration if the value of the underlying declines to zero. In terms of the lower limit, however, a put option cannot be worth less than the difference between the discounted value of the strike price and the current price of the underlying asset.
This system of limits makes it possible to avoid situations of undervaluation or overvaluation of options, while maintaining a market equilibrium in line with the actual value of the underlying assets.
Differences between European and American options
Unlike European options, American options allow the right to be exercised at any time before expiration. This difference results in greater flexibility and, consequently, generally higher value for American options. European options, by contrast, are simpler and more predictable because they limit decisions to the day of expiration. This approach is particularly useful for those who intend to use options as hedging instruments without worrying about intermediate price fluctuations.
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Giuseppe Fontana
I am a graduate in Sport and Sports Management and passionate about programming, finance and personal productivity, areas that I consider essential for anyone who wants to grow and improve. In my work I am involved in web marketing and e-commerce management, where I put to the test every day the skills I have developed over the years.
