Average Price Put

The average price put is a type of "exotic" (meaning out of the ordinary) put option. A put is a bet that the price of the underlying asset will go down. The exotic part comes in because the payoff will be the difference between the average price of the underlying asset over the life of the option and the stated strike price (the original agreed upon price).

Average price puts can be used for speculating or hedging, with the buyer having a generally bearish opinion of the underlying asset.   

Let’s say a pork bellies producer believes prices will be going down. She wants to pig out on puts, buying them to hedge against her exposure (her main product being pork bellies, after all). She decides to hedge 1,000 pounds of bellies. Pork bellies are now trading at $25 per pound and an average price put option expiring in two months can be purchased for $3 with a strike price of $20.

At the end of the two months, when the option is set to expire, the average price of pork bellies was $10 per pound, the producer’s gain would be $7,000 per 1000 pound unit. The underlying put was the right to sell the pork bellies for $20 (i.e. they were at the money at the time) so while the bellies went down 10 bucks, the put's intrinsic value went up $7, net of the $3 premium paid originally for it.