What Is a Spread Option?
A selection option is a kind of option contract that derives its value from the difference, or spread, between the costs of two or more assets. Spread options differ from various option spread strategies constructed with multiple contracts on different strike prices or differing expirations. Aside from the unique kind of underlying asset—the spread—these options act similarly to another kind of vanilla option.
Key Takeaways
- A selection option functions as a vanilla option however the underlying is a price spread quite than a single price.
- The value spread used could be the spread between spot and futures prices (the idea), between rates of interest, or between currencies, amongst others.
- Spread options typically trade over-the-counter (OTC).
Understanding Spread Options
Spread options might be written on every kind of economic products including equities, bonds, and currencies. While some kinds of spread options trade on large exchanges, their primary trading venue is over-the-counter (OTC).
The underlying assets within the above examples are different commodities. Nevertheless, spread options might also cover the differences between prices of the identical commodity trading at two different locations (location spreads) or of various grades (quality spreads).
Some kinds of commodity spreads enable the trader to achieve exposure to the commodity’s production process, specifically the difference between the inputs and outputs. Essentially the most notable examples of those processing spreads are the crack, crush, and spark spreads, which measure profits within the oil, soybean, and electricity markets, respectively.
Likewise, the spread might be between prices of the identical commodity, but at two different deadlines (calendar spreads). example can be an option on the spread of a March futures contract and a June futures contract with the identical underlying asset.
Note that a selection option is not the identical as an options spread. The latter is a technique typically involving two or more options on the identical, single underlying asset.
Spread Option Examples
Within the energy market, the crack spread is the difference between the worth of the refined products—heating oil and gasoline—and the worth of the input—crude oil. When a trader expects that the crack spread will strengthen, they consider that the refining margins will grow because crude oil prices are weak and/or demand for the refined products is robust. Fairly than buy the refined products and sell crude oil, the trader may simply buy a call option on the crack spread.
Similarly, a trader believes that the connection between near-month wheat futures and later-dated wheat futures currently trades significantly above its historical range. This could possibly be as a result of anomalies in the price of carry, weather patterns, or supply and/or demand. The trader can sell the spread, hoping that its value will soon return to normal. Or, they should buy a put spread option to perform the identical goal, but at a much lower initial cost.
Spread Options Strategies
Remember, spread options, that are specific derivative contracts, are usually not options spreads, that are strategies utilized in trading options. Nevertheless, because spread options act like most other vanilla options, a trader can in turn implement an options spread on spread options—buying and selling different options based on the identical underlying spread.
All options give the holder the proper, but not the duty, to purchase or sell a specified underlying asset at a particular price or by a particular date. Here, the underlying is the difference in the worth of two or more assets. Aside from that, all strategies, from bull call spreads to iron condors, are theoretically possible.
The caveat is that the marketplace for these exotic options isn’t as robust because it is for vanilla options. The foremost exceptions can be crack and crush spread options, which trade on the CME group, so the markets there are more reliable. Due to this fact, these options strategies are more available.