Spread trading is a form of options trading, where a combination of options are bought and sold, with differing strike prices and/or expirations dates. In addition, spread trades often make some of their profit from the difference between the cost of the long options and the proceeds of (i.e. the premium received for) the short options, but this is not an absolute requirement.
Spread trades are grouped into either vertical spread trades, horizontal (or calendar) spread trades, or diagonal spread trades, depending upon whether they are constructed using differing strike prices, expirations dates, or both. Within each group, there are many different types of spread trades, such as call spreads, put spreads, bull spreads, bear spreads, credit spreads, and debit spreads.
Spread Trading Example
An example of a spread trade would be a bull call spread, which would be constructed as follows:
- Buy an at the money call option
- Sell an out of the money call option
The bull call spread is a vertical spread trade because it is constructed using different strike prices, but the same expiration date. The bull call spread is also a debit spread trade because the long call option costs more than the short call option, so the trade starts with a loss (albeit a relatively small loss).
The maximum profit for the bull call spread is the difference between the strike prices, minus the initial debit incurred upon entering the trade. The maximum risk for the above bull call spread is the initial debit, which is the difference between the cost of the long and short calls.
Spread Trading Is Not Spread Betting
Despite the similarities in the names, spread trading is not related to spread betting in any way. Spread trading is a form of options trading, whereas spread betting is a form of gambling that is most popular in the UK.
