An Asian option is an option type where the payoff depends on the average price of the underlying asset over a certain period of time as opposed to standard options (American and European) where the payoff depends on the price of the underlying asset at a specific point in time (maturity). These options allow the buyer to purchase (or sell) the underlying asset at the average price instead of the spot price.
Asian options are also known as average options.
There are various ways to interpret the word “average,” and that needs to be specified in the options contract. Typically, the average price is a geometric or arithmetic average of the price of the underlying asset at discreet intervals, which are also specified in the options contract.
Asian options have relatively low volatility due to the averaging mechanism. They are used by traders who are exposed to the underlying asset over some time, such as consumers and suppliers of commodities, etc.
Breaking Down Asian Option
Asian options are in the "exotic options" category and are used to solve particular business problems that ordinary options cannot. They are constructed by tweaking ordinary options in minor ways. In general (but not always), Asian options are less expensive than their standard counterparts, as the volatility of the average price is less than the volatility of the spot price.
Typical uses include:
- When a business is concerned about the average exchange rate over time.
- When a single price at a point in time might be subject to manipulation.
- When the market for the underlying asset is highly volatile.
- When pricing becomes inefficient due to thinly traded markets (low liquidity markets).
This type of option contract is attractive because it tends to cost less than regular American options.
Asian Option Example
For an Asian call option using arithmetic averaging and a 30-day period for sampling the data.
On November 1st, a trader purchased a 90-day arithmetic call option on stock XYZ with an exercise price of $22, where the averaging is based on the value of the stock after each 30-day period. The stock price after 30, 60, and 90 days was $21.00, $22.00, and $24.00.
The arithmetic average (mean) is (21.00 + 22.00 + 24.00) / 3 = 22.33.
The profit is the average minus the strike price 22.33 - 22 = 0.33 or $33.00 per 100 share contract.
As with standard options, if the average price is below the strike price, the loss is limited to the premium paid for the call options.