What Is a Traded Average Price Option (TAPO)?
A traded average price option (TAPO) is an option contract in which the investor's profit or loss is based on the difference between the strike price and the average price, and not solely on the price of the underlying asset at expiration.
First offered in 1987 by the Banker's Trust in Tokyo, TAPOs are also known as Asian options. While the first TAPOs were for oil, the instrument now mainly trades in metals.
- In a Traded Average Price Option (TAPO), the profit or loss is the difference between the strike and the average price of the asset during the term.
- Compared to standard options contracts, TAPOs have a lower premium due to their frequently short lifespan. The premium is also less than exchange-traded contracts due to the way these specific contracts derive their value.
- TAPOs enable traders to manage volatility risk and offer a cost-effective alternative to standard listed options.
How a Traded Average Price Option (TAPO) Works
A traded average price option is an over-the-counter (OTC) product. Its payoff has a basis on the average price of the underlying asset over a specified timeframe. The determination of the average price is at contract creation. For example, settlement values originate from the difference between the strike price and the average price of the underlying asset on dates chosen over the life of the options contract.
Compared to standard options contracts, TAPOs have a lower premium due to their frequently short lifespan. The premium is also less than exchange-traded contracts due to the way these specific contracts derive their value. Rather than a contract having a daily price, you are receiving an average price throughout a specified amount of days. Asian options have a higher risk, which reflects in their lower premiums.
Who Uses Traded Average Price Options?
TAPOs enable traders to manage volatility risk and offer a cost-effective alternative to standard listed options. They are options contracts with a price that is determined by the price of the underlying asset during a period as opposed to a value determined at maturity. TAPOs cost less than regular options and protect investors from market volatility risk. Having an American execution, holders may exercise at any time during the life of the contract on the specified dates. Asian options fall under the category of exotic options, and their use gains favor with commodity suppliers.
Common uses of Asian options include:
- A business that is worried about the average exchange rate over a long period of time
- When a price at a particular point in time could be prone to manipulation
- In the event that the market for an underlying asset becomes highly volatile
- If pricing becomes ineffective because of thinly traded, low liquidity markets
Trading Exchanges for TAPOs
One exchange where TAPOs are commonly traded is the London Metal Exchange (LME), a notable marketplace for futures in non-ferrous metals such as aluminum, copper, lead, and zinc. These call and put options come in contract lengths ranging from one to 27 calendar months, and the monthly average settlement price determines their settlement price. TAPOs, traded options, and futures are all used as hedging tools.