What Does Buy A Spread Mean?
Buying a spread refers to the act of initiating an options strategy involving buying a particular option and selling a similar, less expensive option in a single transaction. Options strategies involving more than one contract at different strike prices are referred to as a spread. Option spreads, like other trading instruments, can be initiated with either a buy or sell transaction. An option spread that is bought implies that it has a net cost and that closing out this option strategy will occur with a sell transaction.
- Option spreads can be bought or sold as a single trade.
- Spreads that are opened with a buy order are usually debit spreads.
- The advantage of trading a debit spread strategy is tightly controlled risk.
- Spreads work best in highly liquid markets.
Understanding How to Buy a Spread
Option spreads come in a wide variety of constructions, each with one or more specialized trading strategies behind them. A spread includes two and sometimes four option contracts. All variations have a buy and a sell order and the spread can be initiated with either. When a spread is bought, all of the different contracts that make up the spread are ordered at the same time. The difference between the buy and ask prices of each contract are combined, and this occasionally leads to improved price efficiency in liquid markets.
Buy orders usually imply that the trader pays money to buy the spread (also known as a debit spread) and hopes to sell the spread when the spread is worth more than was originally paid for it. Buying a spread in this context is to open the trade.
Sell orders can also be used to initiate a trade and when this happens the dynamic is a bit different. Initiating sell orders usually imply that the trader collects money to sell the spread (also known as a credit spread) and hopes to keep some or all of that money as the spread loses value or expires worthless. Buying a spread in this context is to close the trade before expiration.
The strength of an option spread is to carefully limit risk while using leverage to profit from the price fluctuation of the underlying. The strategy works best on highly liquid stocks or futures contracts.
Common Debit Spreads
Options spreads where one contract is purchased with a strike that is at the money, and another contract is simultaneously purchased two or more strikes out of the money, are common amount debit spread trades. Spread trades such as these are called vertical spreads since the only differences between the bought and sold options are the strike prices. The name comes from the options chain display, which lists options vertically by strike prices. The two main vertical debit spreads are directional in nature: bull call spreads and bear put spreads.
Bull call spreads involve purchasing call options at a specific strike price while also selling or writing the same number of calls on the same asset and expiration date but at a higher strike price. A bull call spread is used when a moderate rise in the price of the underlying asset is expected.
Bear put spreads involve purchasing put options at a specific strike price while also selling or writing the same number of puts on the same asset and same expiration date but at a lower strike price. A bear put spread is used when a moderate decline in the price of the underlying asset is expected.
Additional types of debit spreads often traded are calendar spreads, butterfly spreads, condor spreads, ratio backspreads and many other lesser known varieties. In each of these cases the trader buys one in or near the money option and sells a further out-of-the-money option, which creates a net debit in the account. Maximum profit is usually achieved if the underlying asset closes at the strike of the furthest out-of-the-money option.
Advantage of a Buying Spreads
The main advantage of long spreads is that the net risk of the trade is reduced. Selling the cheaper options helps offset the cost of purchasing the more expensive option. Therefore, the net outlay of capital is lower than buying a single option outright. And it carries far less risk than trading the underlying stock or security since the risk is limited to the net cost of the spread.
If the trader believes the underlying stock or security will move by a limited amount between the trade date and the expiration date then a long spread could be an ideal play. However, if the underlying stock or security moves by a greater amount then the trader gives up the ability to claim that additional profit. It is the trade-off between risk and potential reward that is appealing to many traders.