Financial Markets Question and Answer
Q: I’m just beginning to venture into options trading, and am wondering if you could shed some light on what a spread trade is and why it’s useful.
Good question! Let’s first define what an option-spread trade is. A spread is a strategy that involves buying at least one option, while selling another simultaneously. With spread trading, you can create virtually limitless combinations of risk and reward. When most novice traders are introduced to the options arena, they typically begin with simply buying call or put options. While these two strategies can be quite lucrative when you are right, they can also cause quite a bit of damage when you are wrong. There are two primary advantages to spread trades, the first of which is that spread trading allows us to reduce the cost of the trade, thereby reducing the risk. For example, suppose stock XYZ is currently trading at $60, and you want to establish a bullish position. Assessing the current option quotes, you see that the one month 60 call is trading at $6 and the 70 call is trading at $2. Rather than buying the 60 calls outright for $6, we could enter a call spread by buying the 60 call and simultaneously selling the 70 call. This would drop our cost (and max risk) from $6 to $4.
A second advantage of spreads is the ability to place multi-directional trades. In other words, it is possible to create spreads that profit if the underlying stock moves up or down, up or sideways, down or sideways, etc. This allows us to widen the range of profitability, thereby increasing the probability of success. Becoming more comfortable with options spreads necessitates the use of risk graphs. Risk graphs visually portray the risk/reward characteristics of an options trade while also allowing the user to examine “what if” scenarios to see the effects that a change in time or volatility would have on a specific strategy.