Yankee or Continental?

Continuing with my review of option basics, let's look at American vs European style options.

American style options may be exercised at any moment in their lifetime. You can buy an option and exercise it one second later if you like. American style options also settle in the physical delivery of the underlying asset. As a rule, individual stock options are American style.

European style options, on the other hand, are exercised only at the moment of expiration and settle in cash. So, on expiration if the underlying value is 100, holders of he 90 call receive $10 (notwithstanding what they paid for it) and holders of the 100 and above put get nothing. Holders of the 110 put get $10 and holders of the 100 and below call get nothing, etc.

As a rule, index options are European style. It's just too much of a hassle to physically deliver the various components of, say, the S&P 500. This makes trading index options certainly less complicated.

If one trades American style options one must be constantly aware of the possibility of early assignment. With calls early exercise is likely to happen the day before a dividend is paid out. Dividends are only paid to shareholders, not option holders. With puts early exercise is likely to happen the day after the dividend is paid out. If I am holding stock with a very deep in the money (ITM) put, once I've received the dividend there is no longer any reason to carry the position so I exercise my option and "put the stock" away.

Very important! With American style stock options dividends create extra, hidden, expirations. Deep ITM calls for all intents and purposes expire the day before a dividend is paid out and deep ITM puts expire for all intents and purposes the day after the dividend is paid out.

If, as a small investor, you cannot take delivery of the stock then be sure to sell your ITM call before the dividend as the call, like the stock, is likely to lose the amount of the dividend the next day. Similiarly, if you have no stock to deliver and no facility to sell the stock short, be sure and sell your ITM put the day before the dividend as whatever dividend premium was in the put will vanish the next day.

Have a great weekend!