Legal Definitions - European option

A European option is a type of financial contract that grants the holder the right, but not the obligation, to buy or sell an underlying asset (such as stocks, commodities, or currencies) at a predetermined price (known as the strike price) on a specific future date (the expiration date).

The defining characteristic of a European option is that it can only be exercised on its expiration date. This means the holder cannot choose to use their right to buy or sell the asset at any point before that specific date, even if market conditions become highly favorable. This restriction on the timing of exercise distinguishes it from other types of options, like American options, which can be exercised at any time up to and including the expiration date.

Here are a few examples to illustrate how a European option works:

• Stock Market Investment: Imagine an investor, Maria, believes that shares of "TechGains Inc." will increase significantly in value over the next six months. She purchases a European call option for 100 shares of TechGains Inc. with a strike price of $200, expiring in six months. This option gives Maria the right to buy 100 shares at $200 each. However, because it's a European option, she can only exercise this right on the exact expiration date six months from now. If TechGains Inc. stock price soars to $250 after just three months, Maria cannot exercise her option early to buy the shares at $200; she must wait until the six-month mark to make her decision.

• Commodity Hedging for a Business: A manufacturing company, "MetalWorks," needs to purchase a large quantity of copper in nine months for a new production line. They are concerned that copper prices might rise sharply by then. To mitigate this risk, MetalWorks buys a European call option on a specific amount of copper, with a strike price that locks in a favorable cost, expiring in nine months. This option provides MetalWorks with the right to buy copper at the agreed-upon price. Crucially, they can only exercise this right on the expiration date, which aligns with their planned purchase. If copper prices spike in month five, MetalWorks cannot exercise the option early to secure the lower price; they must wait until the nine-month expiration to use their right.

• Currency Exchange for International Trade: An import business, "GlobalGoods," is expecting to receive a payment of 500,000 British Pounds (£) from a UK client in five months. GlobalGoods is worried that the British Pound might weaken against their local currency (Euros) by the time they receive the payment, reducing its value. To protect against this, GlobalGoods purchases a European put option on 500,000 British Pounds, with a strike price that guarantees a favorable exchange rate, expiring in five months. This option gives GlobalGoods the right to sell 500,000 British Pounds at the predetermined rate. However, they can only exercise this right on the expiration date, coinciding with when they expect to receive the payment. If the Pound starts to weaken significantly after two months, GlobalGoods cannot exercise the option early to convert their expected Pounds at the better rate; they must wait until the five-month expiration.