Spread option in EQ
A spread option is an option in which the payout is based on the difference in performance between two assets.
For example, you buy a spread option on Asset 1 and Asset 2, and set a strike of 5% (which means that you are defining the difference between the two assets on the expiry date as 5%). If over the specified time period the value of Asset 1 increases by 15%, and the value of Asset 2 increases by 13%, then no payout is received, as the difference between the two (i.e., 2%) is less than the strike. On the other hand, if the value of Asset 2 only increases by 5%, then a payout is received as the difference in performance (10%) exceeds the strike (5%).
The payout is calculated as:
Notional * Max [w1S1(t)/S1(t0) - w2S2(t)/S2(t0) - K, 0]
- w1 is the weight of asset 1.
- w2 is the weight of asset 2.
- S1 (t) is the value of asset 1 at the expiry date.
- S1 (t0) is the value of asset 1 at the trade date.
- S2 (t) is the value of asset 2 at the expiry date.
- S2 (t0) is the value of asset 2 at the trade date.
- K is the strike (which defines the difference between the two assets on the expiry date), specified as a percentage.
Why enter into a spread option? Equity spread options are primarily used for speculation.
If you believe that based on a recent rise in value of one stock, the value of a second stock which is active in the same sector should now increase, you may sell a spread option. You believe that the performance of the second stock will exceed that of the first stock and thus you will be unlikely to have to pay the buyer.
If you believe that one stock is likely to outperform a second stock, you may buy a spread option. The wider the gap in performance, the larger the payout you receive will be.
In addition, spread options can be used for market neutral investment strategies, strategies whereby the investor seeks to profit from both increasing and decreasing prices in a single or numerous markets. This is because rather than betting on the specific direction of the stock or market, instead a spread option lets you bet on the difference in the performance of two related stocks. For example, you think that a specific stock (Intel) will consistently outperform that of its sector (the Semiconductor sector). So you enter into a spread option where you are in effect buying Intel and selling IGW. Subsequently, if the whole sector collapses you will still be gaining as long as the sector’s index weakens more than the stock you chose; similarly, if the whole sector gains, you will gain as long as the individual stock outperforms the sector’s index.
To price a spread option in SD-EQ:
- In a pricing page, in the Option Class dropdown list click Spread Option, or enter the shortcut SO.
- Enter the strike as a number. For example, to define a strike of 5% (i.e., 5% difference between the value of the two assets on the expiry date) you should enter 0.05.
Define the instrument as necessary, paying attention to the following:
For each asset, in the Initial Spot field, edit the spot if you want its spot at the time of the deal to be different from that of the current spot. Similarly, in the Ref Spot field edit the current spot if necessary.
Note As soon as you change either or both of the initial spot rates/reference spot rates, the spread (which is the difference between changes in both assets and is displayed in the Spread field) is automatically updated.
If the payout currency is different from the asset's currency, check the spot rates and the ATM volatility of the currency pairs involved. You do this by clicking the Currency Options button, changing the data if necessary, and then clicking Accept.
Check that the system has all the correlation data it needs, for example, if the underlying currency of each of the two assets is different. You do this by clicking the Correlation button, filling in any missing data, and then clicking Accept.
In the Funding Rate field, if necessary you can edit the interest rate for the payout currency.