Hedging With Spreads by Bradley J. Horn
A risk manager may prefer the flexibility and limited risk of a call or put strategy. The trader, however, may feel that the premium costs associated with outright option positions are too expensive. These cash flow problems may be overcome with a vertical spread, since this strategy combines the risk-reducing benefits of buying options and the income-generating benefit of selling options.
For example, a transportation company that must acquire gasoline in the future is exposed to the risk of rising prices if the company lacks a fixed-price supply contract for its anticipated inventory needs. Since the firm must purchase gasoline in the future at prevailing market prices, it is short gasoline.
The long hedge protects commercial firms from rising prices by providing an immediate market in which to buy its anticipated inventory. One long hedge alternative utilizing gasoline options is the vertical bull spread. Employing this strategy using calls, the end-user can establish a margin of protection against a rise in gasoline prices without forfeiting the ability to participate in a price decline. In addition, the hedger is able to reduce the cost of the hedge by selling an option and generating income. The trade-off associated with this lower cost is that protection is limited by the strike price of the short call and the hedger still remains exposed to risk should prices rise dramatically beyond the strike price.