What Is Average Price Put?
If the average price of the underlying asset over a specified time period goes over the strike price of the average price put, the payoff to the option buyer is zero.
Conversely, if the average price of the underlying asset is below the strike price of such a put, the payoff to the option buyer is positive and equals the difference between the strike price and the average price.
- An average price put is a form of the option.
- The payoff of an average price put is the difference between the strike price and the average price of the underlying asset.
- Average price puts can be used for hedging or speculating.
- An average price put is known as an exotic option.
How Average Price Put Works
An average price put is an example of a put, an option that gives the owner of an asset the right to sell the underlying asset at an agreed-upon price by a certain date. Puts are called "puts" because their owners have the option to put the asset up for sale.
A put is distinct from a call option. Call options allow holders to buy the underlying at specified upon price before or on its expiration. An average price put is considered an exotic option, since the payoff depends on the average price of the underlying asset over a period of time.
This is opposed to a straight put, the value of which depends on the price of the underlying asset at any point in time. Like all options, average price puts can be used for hedging or speculating, which depends on whether there is an exposure to the underlying asset.
Buyers of average price puts tend to have a bearish opinion of the underlying asset or security.
Example of Average Price Put
Consider an oil and gas producer in the U.S. that believes crude oil prices are set to decline and therefore desires to hedge its exposure. Assume that this producer wishes to hedge 100,000 barrels of crude oil production for one month. Further, assume that crude oil is trading at $90 per barrel, and an average price put with a strike price of $90 expiring in one month can be purchased for $2 by the buyer.
After one month, when the option is about to expire if the average price of crude oil is $85, the oil producer's gain would be $300,000 (i.e. the difference of $5 between the strike price and the average price less the option premium paid X 100,000 barrels).
Conversely, if the average price of crude oil over the one-month period is $93, the option would expire unexercised. In this case, the producer's loss on the hedging transaction would be equal to the cost of the option premium, or $200,000.