By Lawrence G. McMillan
This article was originally published in The Option Strategist Newsletter Volume 4, No. 11 on June 8, 1995.
One of the facets of an option's description is when that option may be exercised. This is usually called the style of the option. For example, American style options may be exercised at any time during the life of the option (in reality, they may be exercised at the end of any trading day). The term, style, is applicable to all options although many investors are not too concerned with it. This is because all listed stock options and all listed futures options are American style, and thus the average investor who trades those types of options is quite accustomed to being able to exercise whenever he wants (or, if he has written the option, he knows that he can be assigned at any time).
There are, however, other styles of options. The most wellknown is the European style option. This type of option can only be exercised on its expiration day. Thus, writers of European style options never have to worry about being assigned prior to expiration. This is a boon to the writer and, as a result, he may receive less of a premium when he initially writes the option.
Since all listed options initially were American style, the European style option was relegated mostly to textbooks or to the occasional direct-party option. Options that trade directly from party to party are generally referred to as "over-the counter" options. However, after index options became popular (with the introduction of OEX options in 1983), certain institutional money managers didn't like the fact that they could be called out of these index options at any time. They lobbied for European-style exercise for index options.
As a result, today most index options are of the European style. In fact, the only index options that are American style are OEX, the Computer Index ($XCI), the Gold & Silver Index ($XAU), the Oil Index ($XOI), the OTC Index ($XOC), the Phone Sector Index ($PNX), the Semiconductor Index ($SOX), and the Utility Index ($UTY). You may notice that most of these are older indices. The newer ones that are American style seem to all be on the PHLX ($SOX and $PNX). There has been considerable pressure in the past to change OEX to European style, since it is such a popular trading vehicle, but the CBOE has generally fought the changes as they are reluctant to alter the terms of an already successful product.
Example: Why the fuss? A simple example may suffice to illustrate the problem. Suppose that you initially bought the following bull spread last spring when OEX was trading near 460:
Bought 5 OEX June 460 calls for 6
Sold 5 OEX June 470 calls for 2
Now suppose that OEX closes one night at 505.61. Since OEX has advanced so far, you have a very nice profit in your position. However, the next morning your broker calls you and tells you that you have been assigned on your short 5 June 470 calls. This means that you have bought them at a price of 35.61 (the previous night's closing price, 505.61 – 470.00, the strike price). You are now "naked" long 5 OEX June 460 calls without any protection
Not only that, but the market opens broadly lower on sell programs that take the Dow down over 30 points and the OEX down over 5 points. By the time you sell your long June 460 calls, OEX has fallen under 500, and you only receive 39½ for them. Thus you have closed out your spread at a credit of 3.89 (39.50 — 35.61) and you initially paid 4 for it, so you are a loser in a bull spread even though OEX advanced by 40 points while you held your position!
This problem could probably have been avoided if the investor in the example had merely closed out his position when it got so far in the money. He also should have watched the time value premium on his short options — if it gets too small (near zero), then the chances of being assigned are much larger than normal.
Traders sometimes relish the vagaries that American style exercise brings to index options, for it allows for more volatility. It also allows for some of the expiration-related trading that we have discussed in the past. However, the average money manager and investor often prefer the European-style of exercise. If one is writing index options — either as protection for his stocks or as part of a spread strategy — he must balance the liquidity available from trading OEX options vis-avis the protection from assignment (and potentially lower price) available with $SPX or other European-style products.
In today's world of exotic (the '90's term for "over-the-counter") options, there is another style of option that is sometimes used, and that is the Bermuda option. This type of option is exercisable at two times: on expiration date, and also on one or more other specified dates prior to expiration. Thus, it's somewhere between an American and a European option, ala Bermuda (get it?).
This article was originally published in The Option Strategist Newsletter Volume 4, No. 11 on June 8, 1995.
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