A brand new option
The NSE is altering the rules of the game in the stock options market
with the introduction of European options from January 2011.
What's proposed
All stock options contracts in the derivative segment of the National Stock Exchange, or NSE, will switch over to European style options. So far, the NSE has offered only American options. The Securities and Exchange Board of India, or SEBI, the market regulator, has cleared the change that will come into effect from January 27, 2011.
What's different
Currently, all the stock options contracts follow the American style. Simply, a call owner buys shares (and the call seller sells shares) while the put owner sells shares (and the put sellers buys shares) at an agreed price on a future date. At present, the buyer of a call or put option can exercise the option at any time before the contract expiry, if his position is "in the money" i.e., he can buy shares at a discount (call buyer) or sell shares at a premium to the stock price (put buyer). Now, in a European style option, the option buyer will be able to buy/sell shares only at the time of contract expiry which falls on the last Thursday of every month.
The inherent advantages…
Market observers believe that the move will improve liquidity in stock options. European options pare the overnight volatility risk in the underlying stock for sellers. Also, American options tend to be costlier. In the American style, an options buyer has to pay a steep premium to the seller because the options holder has many opportunities to use the options and hence that privilege has its price. European options also ensure a level playing field between the buyer and seller of options as there is no early exercise risk. Remember, in American options, the buyer may exercise his right at any time before the contract expiry.
… and the disadvantages
European options lack flexibility because of the predetermined date of exercise. Also, the profit in European options is usually the highest just before expiry and, world over, European options typically stop trading a day before expiration. With liquidity drying up, it becomes impossible for traders to sell the options just before the contract expires.
All stock options contracts in the derivative segment of the National Stock Exchange, or NSE, will switch over to European style options. So far, the NSE has offered only American options. The Securities and Exchange Board of India, or SEBI, the market regulator, has cleared the change that will come into effect from January 27, 2011.
What's different
Currently, all the stock options contracts follow the American style. Simply, a call owner buys shares (and the call seller sells shares) while the put owner sells shares (and the put sellers buys shares) at an agreed price on a future date. At present, the buyer of a call or put option can exercise the option at any time before the contract expiry, if his position is "in the money" i.e., he can buy shares at a discount (call buyer) or sell shares at a premium to the stock price (put buyer). Now, in a European style option, the option buyer will be able to buy/sell shares only at the time of contract expiry which falls on the last Thursday of every month.
The inherent advantages…
Market observers believe that the move will improve liquidity in stock options. European options pare the overnight volatility risk in the underlying stock for sellers. Also, American options tend to be costlier. In the American style, an options buyer has to pay a steep premium to the seller because the options holder has many opportunities to use the options and hence that privilege has its price. European options also ensure a level playing field between the buyer and seller of options as there is no early exercise risk. Remember, in American options, the buyer may exercise his right at any time before the contract expiry.
… and the disadvantages
European options lack flexibility because of the predetermined date of exercise. Also, the profit in European options is usually the highest just before expiry and, world over, European options typically stop trading a day before expiration. With liquidity drying up, it becomes impossible for traders to sell the options just before the contract expires.
