What is an 'Average Strike Option'

An average strike option is an option type where the payoff depends on the average price of the underlying asset over a certain period of time. This contrasts with standard options (American and European) where the payoff depends on the price of the underlying asset at a specific point in time, typically at expiration. These options allow the buyer to purchase (or sell) the underlying asset at the average price instead of the spot price.

Average strike options are also known as Asian options.

BREAKING DOWN 'Average Strike Option'

The strike price sets at maturity, based on the average price of the underlying. Therefore, for an average strike call option to be in the money, the underlying asset must be above the average price at expiration.

There are various ways to interpret the word “average” and that must be specified in the options contract. Typically, the average price is a geometric or arithmetic mean of the price of the underlying asset at discreet intervals, called fixings, which are also specified in the options contract.

Average strike options have relatively low volatility due to the averaging mechanism. They are used by traders who are exposed to the underlying asset over a period of time such as consumers and suppliers of commodities, etc.

Uses for Average Strike Options

Average strike 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), average strike 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:

  1. When a business is concerned about the average exchange rate over time.
  2. When a single price at a point in time might be subject to manipulation.
  3. When the market for the underlying asset is highly volatile.
  4. 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.

Example

For an average strike 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.

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