Spread Options: Definition, Examples, and Strategies for Financial Success

What Is a Spread Option?

A spread option is a type of financial derivative that derives its value from the difference between asset prices. Unlike traditional option strategies, spread options focus on price spreads like those between spot and futures prices. These options primarily trade over-the-counter and can cover equities, bonds, or currencies. Examples like crack and crush spreads offer insight into specific commodity markets.

How Spread Options Work in Financial Markets

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).

The examples use different commodities, but spread options can also cover price differences for the same commodity at two locations (location spreads) or different grades (quality spreads).

Some commodity spreads let traders gain exposure to the production process, focusing on input and output price differences. Notable examples are crack, crush, and spark spreads, which measure profits in oil, soybean, and electricity markets.

Likewise, the spread can be between prices of the same commodity, but at two different points in time (calendar spreads). An example is an option on the spread between March and June futures contracts with the same asset.

Examples of Spread Options

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, or supply and/or demand. The trader can sell the spread, hoping that its value will soon return to normal. Or, they can buy a put spread option to accomplish the same goal, but at a much lower initial cost.

Effective Strategies for Trading Spread Options

Remember, spread options, which are specific derivative contracts, are not options spreads, which are strategies used in trading options. However, 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 same underlying spread.

All options give the holder the right, but not the obligation, to buy or sell a specified underlying asset at a specific price or by a specific date. Here, the underlying is the difference in the 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 options strategies are more readily available.

The Bottom Line

Spread options are derivative contracts based on the price difference between two or more assets, functioning similarly to standard vanilla options. These options can cover various spreads, such as spot and futures prices, interest rates, or currency fluctuations, and are typically traded over-the-counter

Notably, spread options differ from options spread strategies, which involve multiple contracts on a single underlying asset. Understanding the diverse applications, such as crack, crush, and calendar spreads, can provide traders with exposure to unique market dynamics.

However, markets for spread options can be less liquid compared to vanilla options, except for specific markets like crack and crush spread options that trade on established platforms like the CME group. For traders, mastering spread options involves evaluating these market nuances to leverage potential profits or manage risks effectively.