European-style option
Also written European-style options
An option that can be exercised only on its expiry day; the only style permitted for commodity options on Indian exchanges, including options on futures, options on goods and index options.
In plain language
Options come in two exercise styles. An American option can be exercised at any time on or before expiry. A European option can be exercised only on the expiry date.
For commodity options in India the choice is made for you: current regulatory norms permit only European-style options, for Options on Futures, Options on Goods and commodity index options alike.
The practical consequence is that a European option holder who wants out before expiry does not exercise — he sells the option on the exchange.
How it works
The option buyer's three choices (Chapter 4, section 4.1):
- Exercise on the expiration date.
- Sell the option on the exchange before expiry.
- Let it expire unexercised.
Where European style applies in the workbook:
| Product | Result of exercise |
|---|---|
| Options on Futures | Devolve into futures positions at the strike, on expiry day |
| Options on Goods | Devolve into delivery and payment obligations at the strike, on expiry day |
| Commodity index options (SEBI, March 2022) | Cash-settled; at least three strikes; expire at 5:00 pm |
Exercise rules on expiry day.
| Moneyness | Options on Futures | Options on Goods |
|---|---|---|
| ITM | Exercised automatically unless contrary instruction | Same |
| ATM / CTM | Concept of CTM does not apply | Not exercised unless the buyer gives an explicit instruction; CTM = ATM plus 3 strikes above and 3 below |
| OTM | Expire worthless | Those outside CTM lapse |
Reading the symbol. In MAIZE20MAY20CE2100S, CE means a European call with strike Rs 2,100, expiring 20 May 2020, and the final S marks an option on spot goods (an F would mark an option on futures).
A worked example
In early May a miller buys the maize option MAIZE20MAY20CE2100S — a European call on goods, strike Rs 2,100 per quintal, premium Rs 60 (illustrative). The lot is 10 MT = 100 quintals.
On 8 May polled spot maize jumps to Rs 2,300. His call is Rs 200 in the money.
Intrinsic value now = (2,300 - 2,100) x 100 = Rs 20,000
He cannot exercise — it is a European option and expiry is 20 May. If he fears the rally will fade, his only way to lock in value is to sell the option on the exchange, at whatever premium it trades at (which will include some time value on top of the Rs 20,000).
He holds instead. On 20 May the FSP is Rs 2,120:
Strike range for CTM: ATM plus 3 strikes above and 3 below
Intrinsic value at expiry = (2,120 - 2,100) x 100 = Rs 2,000
Premium paid = 60 x 100 = Rs 6,000
If the Rs 2,100 strike falls within the CTM band, it will not be exercised unless he gives an explicit instruction. Exercising would mean paying Rs 2,10,000 against delivery of 10 MT of maize worth Rs 2,12,000 — and the transaction costs on exercise may exceed that Rs 2,000. An American option would have let him exercise on 8 May; the European one gave him only the choice to sell.
Why NISM asks about it
Chapter 4, section 4.2 (Option Terminology), defines American and European options and states that only European commodity options are permitted; section 4.4.4 sets out exercise by moneyness; section 4.6.1 decodes the CE symbol and confirms Options on Goods are European. Chapter 2, section 2.6 (Trading in Index Options), applies the same style to commodity index options. Expect direct definitional questions and a question on which exercise style is allowed in Indian commodity options.
Common exam traps
- European means exercise on expiry day only — not "on or before". That is American style.
- Only European commodity options are permitted in India, for Options on Futures, Options on Goods and index options.
- Getting out early means selling the option, not exercising it.
- CE is a European call; PE a European put. The trailing S or F in the symbol distinguishes goods from futures, not the style.
- ITM exercise is automatic; ATM/CTM on goods needs an explicit instruction. Different default for different moneyness.
- Index options: at least three strikes, cash-settled, expire at 5:00 pm.
- The word refers to settlement style, not geography. The workbook defines "American" and "European" purely by when exercise can happen.
Check yourself
1.Under SEBI's circular of 24 March 2022 on commodity index options, what happens to contracts on the expiry date?
- a)All ITM contracts are exercised automatically unless the buyer has given a contrary instruction; all OTM contracts expire worthless
- b)All ITM contracts expire worthless unless the buyer submits an exercise instruction
- c)All ITM and ATM contracts are exercised automatically and result in delivery of the constituent commodities
- d)The buyer must exercise every contract manually, as these are American-style options
Show the answer
Answer: (a) All ITM contracts are exercised automatically unless the buyer has given a contrary instruction; all OTM contracts expire worthless
On expiry date, all ITM contracts will get exercised automatically, unless the buyer of the option has given a "contrary instruction". All OTM contracts shall expire worthless.
Option (d) reverses the style: these are European-style options, with a minimum of three strikes available for trading — exercisable only on expiry.
Option (c) fails on settlement: index options will be cash-settled on their expiry, with the final settlement price being the index price arrived at from the volume weighted average price of the constituents between 4:00 pm and 5:00 pm on the expiry day. There is no delivery of commodities.
Two further design rules from the same circular: exchanges may introduce index options of up to 12 months expiry, and the expiry date of options shall not coincide with the roll-over of index constituents — because a roll-over is precisely the moment when the index is in transition between contracts.
Also worth carrying into the exam: because index options are cash-settled, there will not be any rolling period or delivery period margin, and all margins — SOMM, initial, concentration, additional adhoc, ELM, pre-expiry — are applicable to the seller, with initial margin applied at the level of the individual client's portfolio.
Where this is taught
Free preparation for NISM Series XVIRelated terms
- MoneynessWhether exercising an option right now would give the buyer a positive, zero or negative cash flow — classifying it as in the money, at the money or out of the money.
- Close to the moneyThe band of option strikes clustered around the at-the-money strike which, in Options on Goods, lapse unless the buyer gives an explicit instruction to exercise them.
- Contrary instructionAn instruction from the holder of an in-the-money option telling the exchange **not** to exercise it — the only way to stop an ITM contract being exercised automatically at expiry.
- Explicit instructionThe instruction an option buyer must actively give to exercise a close-to-the-money or at-the-money commodity option — without it, the option simply expires, unlike an in-the-money option, which exercises automatically.
- Options on FuturesA European commodity option whose underlying is a futures contract, so exercise devolves into a futures position opened at the strike price rather than into delivery of the goods.
- Options on GoodsA European option whose exercise devolves directly into delivery of and payment for the physical commodity, rather than into a futures position.
- Maximum tenorThe 12-month ceiling on a commodity index derivative — an index futures contract may not run longer than 12 months, and index options are permitted up to 12 months of expiry.