In contrast to traditional options (American and European), where the payout is based on the underlying asset’s price at a certain moment, an Asian option’s payoff is determined by the underlying asset’s average price over a specified period of time (maturity).
Instead of paying the spot price, the buyer of these options may buy (or sell) the underlying asset at the average price. Asian Options are usually referred to as average options.
The word “average” might be interpreted in several different ways, and the options contract needs to be very clear. The underlying asset’s price at specific intervals, which are also mentioned in the options contract, is often averaged geometrically or arithmetically to determine the average price.
The averaging process accounts for the relatively low volatility of Asian options. Traders employ them with long-term exposure to the underlying asset, including buyers and sellers of commodities, etc.
Asian Options Explained
Asian options fall under the category of “exotic options,” which are used to address specific business issues that standard options cannot.
They are created by making slight adjustments to common settings. Asian options often cost less than their conventional counterparts. However, this is not always the case because the average price is less volatile than the spot price.
Common uses include:
- When a company is worried about the long-term average exchange rate.
- When a single price at a particular moment could be manipulated.
- When the underlying asset’s market is extremely volatile.
- When prices are inefficient because there are few traders in the market (low liquidity markets).
The fact that this kind of options contract often costs less than standard American options makes it appealing.
Example
Using arithmetic averaging and a 30-day sampling window for an Asian call option.
A trader bought a 90-day arithmetic call option on the stock XYZ on November 1st for $22 with an exercise price depending on the stock’s value after each 30-day interval. After 30, 60, and 90 days, the stock’s price was $21, $22, and $24, respectively.
Arithmetic average (mean) equals 22.33 when we calculate (21+22+24) / 3.
The profit is calculated as the average lower strike price (22.33 – 22 = 0.33 or $33 for a contract of 100 shares).
The loss is restricted to the premium paid for the call options, just like with standard options, if the average price is lower than the strike price.
Takeaways
- Asian option’s payoff is determined by the underlying asset’s average price over a specified period of time.
- The averaging process accounts for the relatively low volatility of Asian options.
- Asian options fall under the category of “exotic options.”
- Asian options contract often costs less than standard American options.
