Average Price Put

What Is Average Price Put?

An average price call is a put option whose profit is determined by comparing the strike price to the average price of the asset that occurred during the option's term. Therefore, for a three-month average price call, the holder of the option would receive a positive payout if the average closing price for the underlying asset traded above the strike price during the three-month term of the option.

By contrast, the profit for a traditional put option would be calculated by comparing the strike price to the price occurring on the specific day when the option is exercised, or at the contract's expiration if it remains unexercised.

Average price options are also known as Asian options and are considered a type of exotic option.

Key Takeaways

  • Average price puts are a modification of a traditional put option where the payoff depends on the average price of the underlying asset over a certain period.
  • This is opposed to standard put options whose payoff depends on the price of the underlying asset at a specific point in time - at exercise or expiry.
  • Also known as Asian options, average price options are used when hedgers or speculators are interested in smoothing the effects of volatility and not rely on a single point of time for valuation.

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. If the average price of the underlying asset over a specified time period ends up being greater than the strike price of the average price put, the payoff to the option buyer is zero. Otherwise, if the average price of the underlying asset remains 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.

This is opposed to a straight, or "vanilla" 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.

Average price puts are part of a broader category of derivative instruments known as average price options (APOs), which are sometimes also referred to as average rate options (AROs). They are mostly traded over-the-counter (OTC), but some exchanges, such as the Intercontinental Exchange (ICE), also trade them as listed contracts. These kinds of exchange-listed APOs are cash-settled and can only be exercised on the expiration date, which is the last trading day of the month.

Some investors prefer average price calls to traditional call options because they reduce the option's volatility. Because volatility increases the likelihood that an option holder will be able to exercise the option during its term, this means that average price call options are generally less expensive than their traditional counterparts.

The complement of an average price put is an average price call, in which the payoff is negative if the average price of the underlying asset is less than the strike price during the option's term.

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.

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