What is a Spread Option
A spread option is a type of option that derives its value from the difference, or spread, between the prices of two or more assets. Other than the unique type of underlying asset - the spread - these options act similarly to any other type of vanilla option.
Important to note is that a spread option is not the same as an options spread. The latter is an options strategy typically involving two options on the same, single underlying asset.
BREAKING DOWN Spread Option
Spread options can be written on all types of financial products including equities, bonds, and currencies. While some types of spread options trade on large exchanges, their primary trading venue is over-the-counter (OTC).
Some types of commodity spreads enable the trader to gain exposure to the commodity's production process, specifically the difference between the inputs and outputs. The most notable examples of these processing spreads are the crack, crush, and spark spreads, which measure profits in the oil, soybean, and electricity markets, respectively.
The underlying assets in the above examples are different commodities. However, spread options may also cover the differences between prices of the same commodity trading at two different locations (location spreads) or of different grades (quality spreads).
Likewise, the spread can be between prices of the same commodity, but at two different points in time (calendar spreads). A good example would be an option on the spread of a March futures contract and a June futures contract with the same underlying asset.
Spread Options Strategies
Again, spread options, which are specific derivative contracts, are not options spreads, which are strategies used in trading options. However, because spread options act as most other vanilla options, a trader can implement an options spread on spread options.
All options give the holder the right, but not the obligation, to buy or sell a specified underlying asset at a specific price at or by a specific date. Here, the underlying is the difference in price of two or more assets. Other than that, all strategies, from bull call spreads to iron condors, are theoretically possible. The caveat is that the market for these exotic options is not as robust as it is for vanilla options. The major exceptions would be crack and crush spread options, which trade on the CME Group, so the markets there are more reliable. Therefore, these combination options strategies are more available.
Using a Spread Option
In the energy market, the crack spread is the difference between the value of the refined products - heating oil and gasoline - and the price of the input - crude oil. When a trader expects that the crack spread will strengthen, they believe that the refining margins will grow because crude oil prices are weak and/or demand for the refined products is strong. Rather 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 relationship between near-month wheat futures and later-dated wheat futures currently trades significantly above its historical range. This could be due to anomalies in the cost of carry, weather patterns, supply and/or demand. The trader can sell the spread, hoping that its value will soon return to normal. Or, he or she can buy a put spread option to accomplish the same goal, but at a much lower initial cost.