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Types of Options
While there are many types of options, options can be classified based on the time when they can be exercised.
European Options Are options that can be exercised on the expiration day, and are usually traded ‘Over the Counter’ (OTC). Some European index options are traded on exchanges. The holder of European option can choose to exercise the option on the expiration day or simply allow it to expire. However, it is recommended that, these holder sells ‘Out of Money’ European options before the expiration day, since European options always trade at a discount to their intrinsic value. American Options Are options that can be exercised on any trading day, either before or on the expiration date. The majority of exchange traded options are American options. These options are usually more expensive than European options, since the buyer has the freedom to exercise these options at any time during the life of the contract. This additional cost can also be called the ‘Early exercise premium’.
Bermudan Options Cannot be exercised before a specified date, however they can be exercised on any trading day after the specified date but prior to the expiration day. Bermudan options behave like European options before the specified date and as American options after the specified date. An Employee Stock Option is a good example of a Bermudan option, where an employee must hold the option for a certain period of time (the vesting period) before the option can be exercised.
Barrier Options These options are similar to a standard option except that they can be activated or exercised when the price of the underlying shares reach a predetermined price, known as the boundary price. This option is cancelled or 'knocked out' if the underlying shares fail to reach the predetermined price level.