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Spread options have a payoff determined by the difference between the prices of two assets and a fixed strike price. These options are often used in commodity markets to hedge the spread between two different underlyings such as WTI vs BRENT oil contracts, can be known as Crack Spread options if there were on Oil vs a derived product such as Heating Oil. 

Similarly, for power generators they may use Spark Spread Options to price options that are based on the the various inputs that can be used to create electrictity.

Spread Option Payoff

spread option payoff

Where;

S1 = Asset 1

S2 = Asset 2

X = Strike

Spread option valuation

Resolution uses the Kirk (1995) approach to value Spread options. If you'd like to try the Spread Option Calculator in ResolutionPro, click here

where

The volatility of  can be approximated by

where

c = Price of European call

p = Price of European put

F1 = Price on futures contract one

F2 = Price on futures contract two

X = Strike price

T = Time to maturity

r = risk free rate

= Volatility of future one

= Volatility of future two

= Correlation between the two contracts

N = The cumulative normal distribution function

 

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