In finance, a general term that is used to denote the class into which the option falls is the style or family of an option. It is usually defined by the dates on which the option may be exercised. The vast majority of options are either European or American (style) options. These options as well as others where the payoff is calculated similarly are known as "vanilla options". Options where the payoff is calculated differently are referred to as "exotic options". Challenging problems in valuation and hedging can be posed by exotic options.
American and European Options
The key difference between American and European options is related to when the options can be exercised:
-
It is possible that a European option might be exercised only at the expiry date of the option, i.e. at a single pre-defined point in time.
-
On the other hand, an American option might be exercised at any time before the expiry date.
For both, the pay-off when it occurs is:
-
For a call option it is via Max [ (S – K), 0 ],
-
For a put option it is via Max [ (K – S), 0 ],:
(Here K is the Strike price and S is the spot price of the underlying asset)
Option contracts that are traded on futures exchanges are mainly American-style, whereas those that are traded over-the-counter are mainly European-style.
