What it means
Many businesses do not care about the absolute price of a commodity as much as the gap between two prices. An oil refinery buys crude oil and sells petrol and diesel, so its profit depends on the difference between the selling and buying prices, known as the crack spread.
A spread option lets that business insure against the gap moving the wrong way. If the gap narrows below a level the refinery can live with, the option pays out and compensates for the squeezed margin.
The payoff for a call spread option is the amount by which the price of the first asset minus the price of the second exceeds the strike, or zero if it does not, while a put spread option pays when the difference falls below the strike. As with any option, the buyer pays an upfront price, called the premium, and cannot lose more than that premium.
Spread options appear in many industries. Power generators use them to protect the gap between electricity prices and fuel costs, a measure known as the spark spread, and metal processors use them to protect the gap between the price of processed metal and the raw ore.
Pricing is more complex than for a standard option because it depends on how closely the two prices move together. If they tend to move in step, the spread varies little and the option is cheaper, and if they move independently, the spread is more volatile and the option costs more.
A common alternative is to hedge each leg separately with its own contract. A spread option can be cheaper and simpler when the real concern is the margin between the two, although it is usually traded over the counter, so each deal is negotiated directly with a bank or dealer.
In practice
Real-world examples.
Example
A refinery worried about a narrowing gap between product prices and crude costs buys a spread option on its monthly output. If the margin collapses, the payout helps cover fixed costs such as wages and maintenance.
Example
A power company with gas-fired plants buys a spread option linked to the difference between electricity and gas prices. It means a rise in fuel costs that is not matched by higher power prices will not wipe out the profit.
Example
A trading desk at a bank sells a spread option to a grain processor that wants to protect its crush margin, the gap between the price of soybean products and the price of the beans themselves.
Formula
Calculation
Payoff = quantity x maximum of (price of asset 1 - price of asset 2 - strike, 0)
A refiner buys a spread option on 10,000 barrels with a strike of $20 per barrel on the difference between petrol and crude oil prices. At expiry, petrol is worth $105 per barrel and crude oil $80 per barrel, so the spread is 105 - 80 = $25. The payoff is 10,000 x (25 - 20) = 10,000 x 5 = $50,000. If the spread had been $18, the payoff would be zero and only the premium would be lost.Case study
Seen in the real world.
Northgate Energy is an illustrative, fictional power producer that runs a gas-fired plant. Its profit depends on the spark spread, which means the price it gets for electricity less the cost of the gas needed to make it. The finance director was concerned that gas prices might rise while electricity prices stayed flat, squeezing the spark spread. She bought a put spread option covering 50,000 units of output with a strike spread of $12, paying a premium of $40,000, so that it would pay out if the spread fell below that level.
Later, a cold winter pushed gas prices up faster than power prices, and the spread fell to $8. The option paid 50,000 x (12 - 8) = $200,000, which more than covered the premium of $40,000 and softened the hit to the plant's margin.
The illustrative lesson is to define clearly which spread movement hurts the business before buying the contract. Northgate wanted protection against a falling spread, so a put on the spread was the right choice, whereas a call on the spread would have paid out in the wrong scenario.
Watch out
Common mistakes.
- Buying a spread option without being clear whether a rising or a falling spread hurts the business.
- Assuming a spread option behaves like two separate options, when its price depends on how the two assets move together.
- Forgetting that most spread options trade over the counter, which brings counterparty risk, the risk that the other side fails to pay.
Questions
People also ask.
What is the difference between a spread option and a spread bet?
A spread option is a contract with a defined strike and premium based on a price difference, while a spread bet is a leveraged wager on the movement of one price.
Can a spread option lose more than the premium?
The buyer cannot, as the premium is the most they can lose, but the seller can face large losses if the spread moves sharply.
What is a crack spread?
It is the difference between the value of refined products, such as petrol, and the cost of the crude oil used to produce them.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%Related