European Options for Stock Options on NSE

By | November 6, 2010 4:10 am

SEBI came out with a circular on 27th November, 2010 giving freedom to Stock Exchanges for choosing style of Options (European / American) on Stocks. It gives flexibility to stock Exchange to offer either European style option or American Style Options.
As of Today Index Options are European Style options and all Stock Options are American style option and after this Decision made by SEBI NSE has decided to introduce European Options on Stocks instead of American Options on Stocks. The implementation date of such change is from January, 2011 contracts which were to be introduced for trading the following day 29th November, 2010.

Let’s find out difference between European and American options and How will it impact Option traders
The key difference between American and European options relates to when the options can be exercised:

* A European option may be exercised only at the expiry date of the option, i.e. at a single pre-defined point in time.
* An American option on the other hand may be exercised at any time before the expiry date.

So after the Introduction of European Option the First Question Comes to a Trader mind is:
Will we be able to trade Options Intra Day and can we square off before Expiry?
As I have told Previously Index Options ie.Nifty Options are European Options, Hence European style options can also be traded intraday can be bought and sold any time of the day or that month. But the change in NSE option style will affect those who used to EXCERISE the option bought/sold at the end of any day now they can EXCERISE their option only at the end of the contract closing day.

For example, an European option [say, index option], if someone has bought 5800 call few days or weeks back with good premium and now if the market crosses 6300 or more, it will be difficult for him to sell those option at a decent price because it will be traded less when compared to 6300 or 6200, even though the intrinsic price value is 500 rupees. So, if he wants, he can sell intraday as per the buyer value or he has to exercise it to get at least the intrinsic value. In index futures this can be done only at the end of the contract day by which time if the index is 5900, he will get just 100 rupees whereas if he had exercised on the day when nifty closed above 6300, he would have got a payout of Rs.[Spot price minus Strike price] which in our case is a minimum of Rs 500/.

Daily exercising facility of American option, which was so far with stock options, is now gone from, January contracts. But still, they can be bought and sold or vice versa like index options intraday/month.

What will be effect on Stock Options when they move to European Options?
With Exchange introducing European stock options for Jan, 2011 series, Traders/Speculators will have to understand that they cannot exercise their options before the expiration date, nor there assignment of any options.
It means they can only sell or buy such options to liquidate their positions, but there will be price (premium / discount) for deep in the money calls and puts. It simply means there will be higher cost on liquidating of positions.
Optimal Exercise of Calls are before the Ex-dividend date and Puts are optimal to exercise as they become deep in the money, but with introduction of European options , things would become simpler but will would also mean that the prices would not deal with all dynamics of market pricing (like Dividends, Open offers, Buy Back).

Why SEBI/NSE decided to move towards European Stock Options?
• To provide liquidty in Stock Options(224 Stocks in F&O) as most of Options are having almost no liquidity.
• FII’s are very active in Index Options but they are not very active in Stock Options. The probable reasons could be higher volatility in stock futures, lower liquidity in stock Options.
• Calculation for Price for European Options is less complicated as compared to American Options.
• Will increase the volume on NSE and income in long run, but I guess we will miss on price discovery process as European options can be easily calculated using Black -Scholes model

c) How would it impact trading and Volume? How would there be change in value of Options?

With introduction of European options, Exchange must be expecting the rise in options volumes. They may be banking on the participation of FII in market making in Stock Options also. I expect that this move may create higher volumes as these are simpler products compared to American Options.

European options are comparatively easier to value using Black Scholes models, where the models takes in to consideration the final price and not the path it moves before such price. Its basic assumption is there are no dividends on the stocks. But that’s a myth in real world.

Impact of dividend on options. As of now all in the money calls were exercised (where Put price was less than dividend) on the eve of stock going Ex – dividend. That was the reason of higher option price. European options cannot be exercised before expiration date and stock may go Ex-dividend during the life of option which may reduce the price of call as dividends cannot be optimized on European options.

Also there will be optimal exercise in cases of buybacks and open offers. Calls can be exercised on last day of trading where the stock can be bought in cash market and buyers can participate in such offers.
Also I perceive that calls price and put prices will fall, ( Technically Implied volatility will reduce) because theoretically Europeans options are cheaper than American options.

To summarise price of options may fall (Lower IV), but Options needs to be carried till expiry (you can sell it).

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