An Asian option is an exotic option that, while bearing some similarities to traditional options, has a different set of qualities that make it an interesting investment alternative. Asian options give investors a payoff based on the average price of an underlying asset, rather than the spot price at a specific time.
This guide will outline the key features of Asian options, as well as how to price them and what the potential benefits and risks of trading them are. We also highlight some of the best strategies for investing in Asian options and answer some of the most commonly asked questions.
What Is An Asian Option?
An Asian option is a derivative where the payoff is dependent on the average price of the underlying asset over a period, as opposed to standard American or European options where the payoff is dependent on the price of the underlying asset at a specific point in time. An Asian option allows the holder to buy or sell the underlying asset at its average price, not one specific price. Asian options are also known as ‘average options’.
The term ‘average’ can be defined in a variety of ways. Generally, the average price of the underlying asset is based on numbers gathered on set dates, a predetermined ‘observation date’. The points in time where the data will be collected are stated in the options contract.
Essentially, an Asian option is formed by taking a standard option and amending it in small ways. They tend to be less expensive than classic options because average price volatility is lower than spot price volatility. Importantly, the trader does not have to be as concerned with large price fluctuations at maturity. And the lower volatility of Asian options tends to make them cheaper for investors.
Here is an example using some of the most common aspects of a typical Asian option; a call option with an average determined using arithmetic pricing…
An investor purchases a 90-day arithmetic call option on stock X on June 1st, and the exercise price is $32. The averaging has been based on the value of the stock after each of the 3 30-day periods:
- On day 30, the stock price is $31
- On day 60, the stock price is $32
- On day 90, the stock price is $34
The arithmetic average is taken: (31.00 + 32.00 + 34.00) / 3 = 32.33
To find the profit, take away the strike price from the average: 32.33 – 32.00 = 0.33, or $33.00 per 100 share contract.
If the Asian option’s average price is below the strike price, then the loss is the total premium that was paid for the call option, as with vanilla options.
History Of Asian Options
The Asian option definition was developed by two London-based bankers working for the Bankers Trust in the 1980s, Mark Standish and David Spaughton. In 1984, the Bank of England give its first licences to banks that allowed them to conduct foreign exchange options on the London market, which is how the Asian option was developed.
Standish and Spaughton announced in 1987 when in Tokyo for business purposes that they had developed the “first commercially used pricing formula for options linked to the average price of crude oil.” Their newly-created exotic option was named the ‘Asian option’ as they were in Asia when they developed it.
An Asian option comes under the category of exotic options, which is the term used for an option that varies from a vanilla option in one or more ways. It also comes under the category of a path-dependent option; an option with a payoff that is dependent on how the underlying asset at maturity was reached, also known as the price path of the underlying asset.
The Asian option is one of the most popular path-dependent options. The main characteristic of an Asian option is that the payoff is determined by the average price of the underlying asset over a predetermined period and at a predetermined set of observation dates which occur over the lifetime of the option.
Other key characteristics include:
- Premiums for Asian options are paid in advance, and they tend to cost less than vanilla options because the possibility of a large payoff is lower.
- The averaging mechanism can either be used throughout the entire lifetime of the option or during a predetermined period at the beginning and/or end of its lifetime.
- They are commonly traded on currencies and commodity products with low trading volumes.
- They can include a non-standard underlying asset that is developed for the investor’s specific needs.
- They are attractive to end-users of commodities or energy products, as users tend to have insight into how prices fluctuate over time.
- Asian options are generally traded over the counter (OTC).
- Exercise style can be specified to provide American early exercise features, which can be favorable to investors looking for more flexibility.
Asian Option Types
There are two types of Asian options. Once the average price of the underlying asset is determined, it can either be used to state the underlying settlement price or the option strike price.
If the average is used to determine the underlying settlement price, then it is an average-price Asian option. This is a cash-settled option, and its payoff is determined by the difference between the average value of the underlying asset during the lifetime of the option.
If the average is used to determine the option strike price, then it is an average-strike option. This type of contract can be cash-settled or physically-settled. It is structured more like a vanilla option, except the strike equals the average value of the underlying asset over the option’s lifetime.
Regardless of the type, Asian options can be both call options and put options, the same way that a vanilla option can:
- An Asian call option gives the holder the right to buy stock/assets
- An Asian put option gives the holder the right to sell stock/assets
Pricing Asian Options: Arithmetic Vs Geometric
Knowing how to price Asian options can be complicated. There are two different ways in which an average can be taken for the price of the underlying asset: arithmetic and geometric.
The difference between arithmetic and geometric-priced Asian options is important when it comes to pricing. The techniques refer to the Asian option payoff formula that is used to value the option.
Geometric Asian options can be priced using what is known as the Black-Scholes formula, an analytical solution that allows for an option to be priced.
With the arithmetic averaging technique, which is more common, an Asian option closed-form solution cannot be used in the same way as with the geometric technique. To accurately price an arithmetic Asian option, numerical methods are used. A common method for pricing arithmetic options is a framework known as the Monte Carlo simulation.
You can also access online calculators that can help you to value Asian options, alongside examples.
Uses For Asian Options
There are many different uses for Asian options, and times when they are more valuable than a standard option. Asian options are often used for currencies, interest rates, commodities and energy markets. Here are some of the key use cases:
- When there is concern about an average exchange rate over a period of time
- During a low liquidity market when the pricing of stock is not favourable
- When the market for the underlying asset is highly volatile
- When a spot price in a market could be manipulated
How Asian Options Work
With every Asian option purchased, a contract is issued to stipulate the terms. Built into every contract is a mechanism of averaging which protects against fluctuating stock prices and prevents major losses. The contract gives the buyer the right, but not the obligation, to buy or sell the underlying asset at the average price rather than the spot price.
The contract will state that the option can be bought or sold at an average price of the underlying asset, and will state the period of time over which the asset is monitored, as well as the dates that the average will be taken on and the number of dates that the average will be based on.
The contract will also state whether the average will be taken from dates throughout the lifetime of the option, or if it will be taken from dates only at the beginning and/or end of the option’s lifetime.
For example, if an option’s lifespan is 90 days, the contract may state that observations will be taken on days 30, 60 and 90, and an average will be determined from the price of the underlying asset on these dates.
Asian options have several advantages over vanilla options…
For one, there is less uncertainty about fluctuations in underlying price at maturity due to the averaging mechanism, meaning there is less risk exposure that typically comes from relying on a spot price. The more observations that are taken, the lower the volatility and the lower the price of the option. This means that they also tend to cost less than American options.
Asian options reduce the vulnerability of the option to market manipulation. Market manipulation refers to when an investor is faced with a misleading appearance of an option, or misinformation making it seem more valuable than it truly is. Market manipulation is not allowed in trading, but it does still happen. The benefit of an Asian option is that the investor is protected because the emphasis is taken away from the closing price due to the averaging mechanism.
Finally, the averaging mechanism can be used throughout the lifetime of the option as well as at the beginning and/or end, so the option can be in line with the needs of the investor making it more flexible.
Averaging any value takes away both the highest and lowest prices of an investment. This means that while the Asian option minimizes risks by eliminating the lowest values, it also means that investors are not able to capitalize on high points in the market that are created by increased volatility. Therefore, the potential for a large payoff is significantly reduced, and the potential profit is not as high.
A vanilla option gives investors the chance to benefit from large spikes in the value of the underlying asset, while the averaging of Asian options takes this away. To some investors, this is compensated for by the comparably lower price of the Asian option, but many would still prefer the opportunity to capitalize on spikes in stock value, for example. For this reason, Asian options are not appealing to all investors, and the lower reward potential should be taken into consideration.
Before you begin trading you must research effective strategies and learn how to employ them. There are lots of approaches and systems to choose from, some simple to complex, but all will have some elements in common. For one, it is helpful regardless of the strategy to use charts and patterns so that you can better predict how prices might change in the future. There are a lot of good indicators that you can also use for your charts, and while the indicator you use may differ depending on your strategy, some of the best include Open Interest, Bollinger Bands, Money Flow Index, Put Call Ratio Indicator and Relative Strength Index.
It is also important that no matter what strategy you are using you take the time to consume the right kinds of information about your trading plan. This can be anything from ebooks and videos to PDFs.
Delta hedging is a trading strategy for options that works to minimize (or hedge) the risk of price fluctuations of the underlying asset. Delta hedging uses options to reduce the risk to either one other option or a portfolio of holdings. As a strategy, it is supposed to be directionally neutral and can help to isolate volatility changes for the investor.
At a basic level, delta hedging is when an investor is buying or selling options and offsetting the risk by buying or selling the equivalent amount of stock or shares. The ‘delta’ represents a change in the value of an option due to the change in the market price of the underlying asset. So, if a stock option for a share has a delta of 0.50, and the underlying asset increases its market price by $1 per share, then the value of the option on the share rises by $0.45 per share.
Now, let’s look at Asian option delta hedging more specifically. Taking the example of Delta Hedging given in Frans de Weert’s ‘Exotic Options Trading’, we can see how delta hedging can be an effective strategy for trading Asian options. A real example is as follows:
A trader sells 90,000 3-month Asian call options with a strike price of $40 after 3 observations in total. Each option allows the investor to purchase 1 stock. In the beginning, the Asian option delta is similar to a European option which is approximately 50%, so the investor delta hedges by buying 45,000 shares of stock.
If on the observation date, around 30 days later, the stock is trading at $48, then the delta of the option is larger than the equivalent European option, because the first Asian setting is most likely to be more than $40.
Now let’s say that the Asian delta is 75,000 shares, and the equivalent European one is 67,500 shares. The first Asian setting is certain to be ITM (delta = 1), making up one-third of the portions in the arithmetic average. This means 30,000 shares out of 75,000 act as a delta hedge for the first Asian setting. The 30,000 shares will be sold after the first Asian setting and therefore 45,000 will remain as the investor’s delta hedge.
The remainder of the Asian option is now 60,000 shares.
Now say that after the first observation date the stock price dramatically decreases, and by the second observation day, it is trading at $32. The delta hedge is now down to 10,000 shares as a result. The second Asian setting is now sure to be OTM (Delta = 0). Nothing now needs to be done at the close of the second Asian setting, and it can be concluded that the delta for the third observation is ⅓ (10,000/30,000).
By the third observation, the stock is back to trading at $42 so is back to ITM (delta = 1), so the investor holds 30,000 shares as a delta hedge. These shares must be sold at the close of the final Asian setting.
This example shows that the duration of the Asian option is shorter than the European equivalent, and since the option price is higher when the time to maturity is higher, the price of the Asian option should be smaller than that of an equivalent European option.
It is worth noting that a drawback of Asian option hedging is that the positions must be constantly watched and adjusted, which can bring about a trading cost while delta hedges are added and taken away due to changes in the underlying price.
How To Start Trading Asian Options
Before starting to trade, you will need to open a brokerage account. You can choose from a selection of online brokers, and find one that fits your specific needs. Some of the key things to keep in mind when choosing a provider include:
- Commission prices – There will be varying commission prices between different brokers, so choose one that is in line with your budget and ensure that there are no hidden costs.
- Account types – Think about whether you want to day trade with a cash account or a margin account, i.e. do you want to only trade with the capital you have or do you want to be able to borrow money from your broker?
- Trading platform – Choose a trading platform that offers technical tools that help you to invest in the best way possible, and ensure that the platform has the infrastructure that suits your needs.
Once you have a broker, the next step is to study the market. Make use of the resources that are available to you and ensure that you stay up to date on the state of the market so that you are aware of any changes. Furthermore, take a look at Asian option calculators and pricers online to simulate your experience beforehand.
Final Word On Trading Asian Options
The Asian option can be tailored to meet the specific requirements of the trader and serves as a lower-cost investment opportunity that protects against dramatic price fluctuations in the market as well as market manipulation. But while trading in Asian options can minimize risk and protect your capital, it is also worth noting that the payoffs are not likely to be as large as with other kinds of options.
Are Asian Options Cheaper Than Vanilla Options?
Due to the averaging mechanism of Asian options, they tend to be cheaper than European and American contracts. This is because Asian options reduce the overall volatility of the option.
What Is The Difference Between American, European And Asian Options?
Asian options differ from American and European alternatives in that an Asian option is a trading tool where the payoff depends on the average price of the underlying asset, whereas with American and European options, the payoff depends on the price of the underlying asset at a specific point in time.
What Is The Volatility Of Asian Options?
Asian options have low volatility in comparison with other kinds of options due to the averaging technique that is used to determine the strike price.
How Do I Find Out The Valuation Of Asian Options?
Asian options can be priced in two different ways, arithmetically and geometrically. These are how the average is taken from different observation dates and the price of the underlying asset on each date. Asian option pricing calculators can also be found online.
Who Should Invest In Asian Options?
Asian options are popular with larger corporations but are also a great tool for independent investors who are end-users of the products and commodities on these markets. Importantly, they can benefit those who are aware of the price fluctuations that occur in respective markets.