What is spread hedging?

Spread hedging refers to a limited-risk strategy used by options traders. Options are financial contracts that grant the purchaser, or owner, a legal right to buy or sell an investment asset prior to a specific date or at a specific price. They are called "options" because the owner is under no obligation to exercise his or her right; the seller of the option assumes the obligation and must execute when the buyer chooses to exercise his or her right as long as it is within the confines of the contract.

The term hedging can be used to describe any risk management technique, and one type of hedging strategy for options trading is referred to as an "options spread." Conservative in nature, spread option trades sacrifice a portion of upside potential to reduce exposure to loss.

One basic option spread combines two different option strikes, or the price at which an option can be exercised by the buyer, which are referred to as "legs." An investor using a two-leg strategy may combine a call option bought with a call option sold, which allows the investor to take both sides of the market. While relatively simple in theory, option spreads can be quite complex and tricky to execute.

All spread hedges involve more than one strike price. These strike prices offset each others' risk to a certain degree but also introduce a new type of risk: the risk of incorrectly pricing and timing the strikes in relation to one another. A basic vertical option spread, as described above, ensures that if one option makes money, the other loses money. Correctly identifying and executing profitable relationships is the number one hurdle for all spread option traders.