What does Buy A Spread mean?
Buying a spread is an options strategy involving buying an option with one strike and selling an option with a different strike but all with the same underlying asset and expiration date. The purchased option has a higher price than the sold option. Both options can be calls or they can be puts.
This is also called a long spread or a debit spread because, as with buying any asset, the trader must pay up front to initiate the trade.
A long call spread is a bullish strategy. A long put spread is a bearish strategy.
The opposite trades are called selling a spread, short spreads or credit spreads. Therefore, a short call spread is bearish and a short put spread is bullish. Both result in a net credit to the account at the start of the trade.
BREAKING DOWN Buy A Spread
Options spreads 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.
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.
In short, the trader buys the in-the-money option and sells the out-of-the-money option, which creates a net debit in the account. Maximum profit is achieved if the underlying asset closes at the strike of the original out-of-the-money option. It is equal to the difference between the strikes minus the net debit paid to initiate the trade.
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 tradeoff between risk and potential reward that is appealing to many traders.