What Is an Average Strike Option?
An average strike option is a type of option where the strike price depends on the average price of the underlying asset over a specified period of time. The payoff is the difference between the price of the underlying at expiry and the average price (strike). Average strike options are also known as Asian options.
- The strike price for an average strike option is set at expiry based on the average price over the option's life.
- The payoff for an average strike call is the price of the underlying at expiry less the average price (strike).
- The payoff for an average strike put is the average price (strike) less the underlying's price at expiry.
- When buying an average strike option, the risk is limited to the premium paid.
Understanding an Average Strike Option
With an average strike option, the strike price sets at maturity, based on the average price of the underlying. This is different than an American or European option, where the strike price is known at the time of the initial purchase.
For an average strike call option to be in the money (ITM), the underlying asset's price must be above the average price (strike) at expiration. For a put option to be ITM, the underlying's price must be below the average price (strike) at expiration.
How the average is calculated must be specified in the options contract. Usually, the average price is a geometric or arithmetic mean of the price of the underlying asset. The data points are taken at pre-determined intervals, called fixings, which are also specified in the options contract. Different averaging techniques, or the number of data points, will affect the average price. Therefore, it's important to understand how the averaging will be calculated.
Average strike options have lower volatility than standard American or European options due to the averaging mechanism. This means they are typically cheaper than a comparable American or European option. They are used by traders who want exposure to an average price, or that have exposure to an underlying product, like a commodity for a period of time, and therefore want an average price option to cover that commodity for that period of time.
Uses for Average Strike Options
Average strike options are exotic options, and help traders find solutions to problems that normal options may not.
A trader or business may use an average strike option if:
- They want an average exchange rate or price over time.
- They feel the average price is less subject to short-term manipulation around the expiry, which standard options may be exposed to.
- They want to decrease the volatility of the option by using an average.
- They want an average price for a thinly traded underlying market because pricing in the underlying market may be inefficient from day to day, but more stable when averaging the price over time.
Average Strike Option Example
On November 1st, a trader purchases a 90-day arithmetic average strike call option on stock ABCDE. The stock currently trades at $50 and averaging is based on the value of the stock after each 30-day period.
The stock price after 30, 60, and 90 days is $48, $53, and $56 and the arithmetic average price of the underlying is ($48 + $53 + $56) / 3 = $52.33. The profit is the price of the underlying at expiry less the average price (strike). Assume the stock is trading at $54.50 at expiry. $54.50 - $52.33 = $2.17 or $217 per 100 share contract.
If the underlying's price at expiry is below the average price (strike) then the call option is out of the money (OTM). Conversely, if the price at expiry is above the average price (strike) then the call option is ITM. For a put option, if the underlying is below the average price (strike) the option is ITM, and it is OTM if the underlying's price is above the average price (strike).
If the option is OTM, the loss is limited to the premium paid for the option.