What Are European and US Style Options

When dealing in options there are two styles, European and US. Confusingly the terms have nothing to do with the different continents.

European style options can only be exercised on the day of expiry.

For example if you owned the IBM June $65 call with the shares at $75, you can't exercise this option and receive the shares until the expiry day. Of course the Option will still be freely tradable in the market place enabling a profit or loss to be taken.

US style options can be exercised at any time on or before expiry.

If you owned the BT Dec £1.50 call when the shares are trading at £1.75 you could exercise the Option and take delivery of 1,000 shares at any time before the December expiry date.

All options on UK equities are US style and are therefore more flexible. Although they trade both the US and European style options on the FTSE 100 index, most, if not all, of the business is done in European style.

When you have the choice of dealing in either Option always go where the volume is because they’re cheaper to trade via tighter bid-offer spreads.

Option Volatility

Volatility is the most overlooked and dominant factor of option trading.

Volatility affects the price of an option today and its price in the future. Sadly, many retail clients lose unnecessary money with Options because they either don't fully understand what they're doing, or don't have a solid grounding in the products that they're trading.

And trading without understanding the impact that volatility plays, is just one reason why many people get sub-standard results with Options.

• Think of volatility in terms of car insurance
  
  
• Car insurance is simply about risk, so a 25 year old wanting to insure a Porsche will incur a dramatically higher premium than a 55 year old
  
  
• If you were the insurance company, would you not demand a higher premium for doing business with the 25-year-old?
  
  
• Translate this example into options: the high-risk 25 year old is a technology share, with the low risk 55 year old a utility company like British Gas

Or to look at it another way, what is the chance of a share in the telecom sector doubling or going broke within a year compared with a staid utility company?

How Is Volatility Measured?

The measurement of volatility is shown as a percentage.

If the option volatility of Vodafone is 20% and the shares are priced at £1.00 then the options market is expecting the share price to fluctuate between £0.80 and £1.20 over a year. It is important to understand that this is not a forecast about the future direction but rather an indication of the moves either up or down that are likely to occur.

What you must never forget about option volatility is that it's always changing and today's reading may differ markedly from that of the future. When trading options your view on the future direction of volatility is sometimes far more important than your forecast for the underlying product.

Two types of Volatility

Option volatility comes in two forms, historical and implied.

Historical volatility is derived from past data, usually the previous x number of daily closes.

While implied volatility considers not only what has happened in the past, but also takes a view on the future.

Imagine there was going to be a General Election tomorrow between two parties, A and B -

• If party A won the stockmarket would open higher by 20%
• If party B won it would open down 20%
• In the weeks leading up to the result both parties were neck and neck, . everyone had a view but the view was split right down the middle

Chances are as the election got closer the stockmarket would get less movement as half the market participants had entered their trades, and the other half had stayed out.

If this were to happen then historical volatility would decline because of the lack of movement. But implied volatility would remain high because of the potential for a major move in stocks once the result of the Election in known.

If you're using volatility then pay more attention to the implied rate.

Don't worry too much about the intricacies of the different types of volatility or how they are calculated. What is important is to keep it simple, understand it, and always be aware at what level it's trading especially if at historically high or low levels.

A Simple Rule For Volatility

A general rule for volatility is –

• Volatility rises in a falling market, and
• Volatility falls in a rising market

Think about it, prices are always more volatile when they’re heading down. Plenty of examples of stockmarket crashes over the last 200 odd years but not many examples (if any) of the overall market rising 20% in a given day.

During the global banking crisis of 2008 option volatility obviously went through the roof over a matter of days and weeks during September/October.

But when stocks were steadily heading higher from 2003 – 2007 Option implied volatility moved to very low levels. Options during this time were considered cheap to buy but dangerous to sell short.