What Is an Asian Option?
An Asian option is an option type where the payoff depends on the average price of the underlying asset over a certain period of time as opposed to standard options (American and European) where the payoff depends on the price of the underlying asset at a specific point in time (maturity). The arithmetic average (mean) is (21.00 + 22.00 + 24.00) / 3 = 22.33. The profit is the average minus the strike price 22.33 - 22 = 0.33 or $33.00 per 100 share contract. As with standard options, if the average price is below the strike price, the loss is limited to the premium paid for the call options. Typical uses include: 1. When a business is concerned about the average exchange rate over time. 2. When a single price at a point in time might be subject to manipulation. 3. When the market for the underlying asset is highly volatile. 4. When pricing becomes inefficient due to thinly traded markets (low liquidity markets). This type of option contract is attractive because it tends to cost less than regular American options. Typically, the average price is a geometric or arithmetic average of the price of the underlying asset at discreet intervals, which are also specified in the options contract.
Asian options are also known as average options.
There are various ways to interpret the word “average,” and that needs to be specified in the options contract. Typically, the average price is a geometric or arithmetic average of the price of the underlying asset at discreet intervals, which are also specified in the options contract.
Asian options have relatively low volatility due to the averaging mechanism. They are used by traders who are exposed to the underlying asset over some time, such as consumers and suppliers of commodities, etc.
Breaking Down Asian Option
Asian options are in the "exotic options" category and are used to solve particular business problems that ordinary options cannot. They are constructed by tweaking ordinary options in minor ways. In general (but not always), Asian options are less expensive than their standard counterparts, as the volatility of the average price is less than the volatility of the spot price.
Typical uses include:
- When a business is concerned about the average exchange rate over time.
- When a single price at a point in time might be subject to manipulation.
- When the market for the underlying asset is highly volatile.
- When pricing becomes inefficient due to thinly traded markets (low liquidity markets).
This type of option contract is attractive because it tends to cost less than regular American options.
Asian Option Example
For an Asian call option using arithmetic averaging and a 30-day period for sampling the data.
On Nov. 1, a trader purchased a 90-day arithmetic call option on stock XYZ with an exercise price of $22, where the averaging is based on the value of the stock after each 30-day period. The stock price after 30, 60, and 90 days was $21.00, $22.00, and $24.00.
The arithmetic average (mean) is (21.00 + 22.00 + 24.00) / 3 = 22.33.
The profit is the average minus the strike price 22.33 - 22 = 0.33 or $33.00 per 100 share contract.
As with standard options, if the average price is below the strike price, the loss is limited to the premium paid for the call options.
Related terms:
American Option
An American option is an option contract that allows holders to exercise the option at any time prior to and including its expiration date. read more
Asian Tail
An Asian tail is an option that pays out based on the average price of the underlying in the last several days or weeks of the contract's life. read more
Average Strike Option
An average strike option is an option where the payoff depends on the average price of the underlying asset instead of a single price at expiration. read more
Average Price
Average price is the mean price of an asset or security observed over some period of time. read more
Average Price Put
An average price put is a type of option where the payoff depends on the difference between the strike price and the average price of the underlying asset. read more
Call Option
A call option is a contract that gives the option buyer the right to buy an underlying asset at a specified price within a specific time period. read more
Commodity
A commodity is a basic good used in commerce that is interchangeable with other goods of the same type. read more
European Option
A European option can only be exercised on its maturity date, unlike an American option, resulting in lower premiums. read more
Exchange Rate
An exchange rate is the value of a nation’s currency in terms of the currency of another nation or economic zone. read more
Exotic Option
Exotic options are options contracts that differ from traditional options in their payment structures, expiration dates, and strike prices. read more