characteristic of the natural gas market highlights another feature of average price options; they reduce the incentives to manipulate the underlying price at expiration.⁸

Averaging is usually done via an arithmetic average though a weighted average can also be used. The difficulty which this poses is that the options cannot be valued using a closed-form pricing solution. The basic Black-Scholes option pricing formula is not applicable since an average of prices will not be lognormally distributed even though the individual component prices will.⁹ Consequently, models used to price these options consist of numerical solutions or approximations. For example, Monte Carlo models are often used to value average price options.

Popular option strategies in the energy sector include caps (long calls), floors (long puts) and collars (long a higher struck call and long a lower struck put). For a producer who is long the physical commodity, purchase of an aver­age price floor struck at $18 affords that producer protection against average oil prices dropping below $18. For an end-user who is exposed to the risk of rising prices (equivalent to having a short position in oil) purchase of an oil cap sets a limit on the price to be paid to secure the commodity. A zero-cost collar is yet another strategy which may be employed by producers. By selling a cap and buying a floor with the proceeds, producers can lock in a trad­ing range above and below which price fluctuations will not affect them. They effect a trade-off between the possibility of upward price appreciation and the comfort of protection against price deterioration.