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| In [[finance]], a '''spread option''' is a type of [[Option (finance)|option]] where the payoff is based on the difference in price between two underlying assets. For example the two assets could be crude oil and heating oil; trading such an option might be of interest to oil refineries, whose profits are a function of the difference between these two prices. Spread options are generally traded over the counter, rather than on exchange.<ref>[http://www.global-derivatives.com/index.php/component/content/46?task=view Global Derivatives: Spread option]</ref><ref>[http://www.investopedia.com/terms/s/spreadoption.asp#axzz1xK58zM00 Investopedia:Spread option]</ref>
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| A 'spread option' is not the same as an 'option spread'. A spread option is a new, relatively rare type of [[exotic option]] on two underlyings, while an option spread is a combination trade: the purchase of one (vanilla) option and the sale of another option on the same underlying.
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| ==Spread option valuation==
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| For a spread call, the payoff can be written as <math>C = \max(0,S_1-S_2-K)</math> where S1 and S2 are the prices of the two assets and K is a constant called the strike price. For a spread put it is <math>P = \max(0,K-S_1+S_2)</math>.
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| When K equals zero a spread option is the same as an option to exchange one asset for another. An explicit solution, [[Margrabe's formula]], is available in this case.
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| In 1995 Kirk's Approximation,<ref>Kirk E. (1995); Correlation in the Energy Markets, in: Managing Energy Price Risk, Risk Publications and Enron, London, pp. 71–78</ref> a formula valid when K is small but non-zero was published. This amounts to a modification of the standard [[Black-Scholes]] formula, with a special expression for the sigma (volatility) to be used, which is based on the volatilities and the correlation of the two assets.
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| The same year Pearson published an algorithm<ref>[http://papers.ssrn.com/sol3/papers.cfm?abstract_id=7010 N. Pearson: An efficient approach for pricing spread options]</ref> requiring a single numerical integration to compute the option value.
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| This method was improved upon in 2006 when Li, Deng and Zhou<ref>Li, Deng and Zhou: Closed-Form Approximations for Spread Option Prices and Greeks [http://papers.ssrn.com/sol3/papers.cfm?abstract_id=952747]</ref> published accurate approximation formulas for both spread option prices and their Greeks.
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| ==References==
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| {{Reflist}}
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| {{DEFAULTSORT:Spread Option}}
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| [[Category:Options (finance)]]
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| [[Category:Derivatives (finance)]]
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| {{finance-stub}}
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