Trading Average Price Option TAPO What It is How it Works
Contents
Trading Average Price Option (TAPO): What It is, How it Works
What Is a Traded Average Price Option (TAPO)?
A traded average price option (TAPO) is an option contract where 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 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.
Key Takeaways
- In a Traded Average Price Option (TAPO), the profit or loss is the difference between the strike and 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 how 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 is based on the average price of the underlying asset over a specified timeframe. The average price is determined at contract creation. For example, settlement values come from the difference between the strike price and average price of the underlying asset on chosen dates throughout 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 how these specific contracts derive their value. Instead of a contract having a daily price, you receive an average price over a specified number of days. Asian options have higher risk, which is reflected 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 determined by the price of the underlying asset during a period, rather than a value determined at maturity. TAPOs cost less than regular options and protect investors from market volatility risk. With American execution, holders may exercise at any time during the life of the contract on the specified dates. Asian options are considered exotic options and are favored by commodity suppliers.
Common uses of Asian options include:
- A business concerned 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 due to 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.
