A European option is an options contract that can only be exercised on the expiry or expiration date. European options are contrasted with American options that can be traded at any time on or before their expiry or maturity date.
European Options in Trading
Despite the name, the use of European options in trading is not a matter of geographic location. Rather, European options are used as derivatives for securities that have a naturally high rate of volatility around a mean that changes little.
Therefore, these securities tend to fluctuate significantly, but within a limited and generally unchanging range.
This means that most options tied to that security will be in the money at some point, which would make an American style exercise system have little value for the writer of the option.
European options are most commonly used as derivatives for indices, which generally follow the above pattern. The most notable example is the VIX, or volatility index, which swings dramatically, but generally within a limited set range.
While the VIX will often touch both the upper and lower bound of its general range in any given period of a week or more, it is much more difficult to predict where it will be at the end of that period.
This makes a European option both useful to buyers who need to hedge their exposure on a certain date and to sellers who want to profit from the writing of the option.
In situations where both European options and American options are used, the European options tend to trade at a discount as a result of their more limited exercise range.
European options are most commonly used in situations where the more standard American option would make little sense. European options allow the option writer the opportunity to profit while still providing the buyer with the necessary hedging exposure that drives much of the demand for options.