DEFINITION of 'Average Price Put'

A type of option where the payoff depends on the difference between the strike price and the average price of the underlying asset. If the average price of the underlying asset over a specified time period exceeds 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 is the difference between the strike price and the average price. An average price put is considered an exotic option, since the payoff depends on the average price of the underlying over a period of time, as opposed to a straight put, the value of which depends on the price of the underlying asset at any point in time.

BREAKING DOWN 'Average Price Put'

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 may generally have a bearish opinion of the underlying asset or security.

For example, consider an oil and gas producer which holds the view that 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.

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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