What is a spread trade? It depends on the products you trade. For a stock trader it could be a pairs trade, and for an options trader there are plenty of ways to put on a spread trade.
What is a spread trade? The answer depends on the type of investor or trader you are. You could look at spread trading as a figurative bridge across different asset classes (stocks and commodities, for example), different markets or countries, or even time (say, this month and next month) to help you make progress toward your investing goals.
Professional investors and traders use spread trades through a variety of avenues: futures spreads, options spreads, so-called pairs trading, and more. Individual investors can apply spread trading strategies as well, according to Harrison Napper, senior product manager at TD Ameritrade. But it’s critical to first understand how spread trading works, as well as your investing or trading mentality.
The following are a few key questions and basics on spread trading:
Broadly speaking, a spread is a market position that has two or more “legs,” including a “long” position that, in theory, gains value if the price of the underlying asset rises, and a “short” position that gains if the price declines. The “spread” is basically the price difference between the long position and the short position.
Part of the goal “is to find some kind of relationship between two things,” Napper said. “Effectively, you’re trading the relationship, not the two assets.”
Often, the rationale behind a trading strategy involves a tradeoff: limiting risk in exchange for limiting upside potential. Many spread traders aim to hedge or insulate against short-term volatility or price declines in a stock or other asset, yet still hold on to shares of that asset. In most cases, spread trading allows traders to define their risk.
Some investors strive to track the S&P 500 or other broad market benchmark over the long haul. Spread traders, by contrast, may be thinking more aggressively and trying to do better than the broader market. Or they may aim to play a short-term hunch without affecting their longer-term strategy or goals.
“If you’re comfortable doing about the same as the rest of the market, you may not want to use spreads,” Napper said. “If you want to attempt to do better than the rest of the market, and you’re comfortable with the risks involved, then options-based spreads can help you attempt to do that. Spreads offer a tool to more finely-tune your trade ideas.”
A calendar spread can be created using any two options of the same stock, strike, and type (either two calls or two puts), but with different expiration dates.
For example, if a stock is trading at $50, and you think it will hold a tight range around that price for at least a few weeks, you might buy one November $50 call for $2 and sell one October $50 call for $1.25 (also your maximum risk). You’d then own a long October/November calendar for $0.75 debit (not including transaction costs).
How do you profit? If the shorter-term option “decays” faster than the longer-term option, the spread “widens” and you may be able to close out the spread for a profit.
All things being equal, if the stock finished at $50 at expiration of the short option, your short option would be worth zero while the long option might now be $1.25. Since your long spread has “widened” from $0.75 to $1.25, your profit is $0.50 (less transaction costs).
Learn more about calendar spreads.
A calendar spread is considered a defined-risk strategy that involves selling a short-term option and buying a longer-term option of the same type (calls or puts).
Calendars are designed to profit from the passing of time, not a stock’s movement. Over time, the goal is for the shorter-term option to “decay” faster than the longer-term option, so the position profits when the spread can be sold for more than you paid for it (risk is typically limited to the debit incurred).
Calendars and other options-based spreads can be applied to prepare for near-term events, such as quarterly earnings, Napper said.
Say you hold shares in a company you believe is a solid longer-term investment, but you’re concerned about disappointing quarterly earnings that could send the stock into a temporary tailspin. An options-based spread could, if earnings do indeed fall short, allow you to pocket a gain from any drop in the stock without having to sell any actual shares.
A vertical spread is typically an options position composed of either all calls or all puts, with long options and short options at two different strikes. The options are all on the same stock and of the same expiration, with the quantities of long options and short options balancing to zero.
Feeling bullish? That’s when a long call or short put vertical may serve you. Alternatively, long put and short call verticals are considered bearish positions. In addition to transaction costs, the risk of a long vertical is typically limited to the debit of the trade, while the risk of the short vertical is typically limited to the difference between the short and long strikes, less the credit.
A collar spread—which involves a short call and a long put along with a long stock position—is another common options-based spread trade. Part of the idea is to have the premium collected from a short call offset the premium paid for a put, limiting your upside potential but protecting against a price drop in the underlying stock. (Learn more about other forms of spread trading, including the iron condor.)
A common spreading tactic in equities, pairs trading often involves taking a bullish position in one stock or ETF (buying 100 shares or buying call options, for example), while also taking a bearish position in another (shorting another company’s stock or buying put options).
Pairs trading often involves stocks that are positively correlated and/or in the same industry, meaning the shares usually move in the same direction over long periods. Pairs trading can also be applied to bonds, currencies, and other assets.
Pairs traders keep their eyes open for opportunities when two historically correlated stocks diverge—one stock moves up while the other moves down—then take a market position that, in theory, will make money when the two stocks eventually converge again. For examples of pairs trading, see “Pairs Trading: Your Yummy New Snack.”
Spread trading can be a valuable component of an investing strategy for some investors, but Napper cautioned it can also get very complicated, very quickly. Throw in leverage (borrowed money), and spread trading can go beyond relatively straightforward hedging into the realm of speculation. In fact, many traders use spread trading exclusively for speculation.
It’s important for investors considering spread trades to grasp the difference between hedging and speculation, Napper said. Spreading “can be a highly-leveraged way to make money very quickly—or lose money very quickly.” Hedging and speculating are among the tools of a long-term strategy. As investors, “Some will want to be able to use both these tools, but must understand the risks first.”
While options are definitely not for everyone, if you believe options trading fits with your risk tolerance and overall investing strategy, TD Ameritrade can help you pursue your options trading strategies with powerful trading platforms, idea generation resources, and the support you need.
Learn more about the potential benefits and risks of trading options.
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Content intended for educational/informational purposes only. Not investment advice, or a recommendation of any security, strategy, or account type.
Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
Pairs trading requires active monitoring and management and is not suitable for all investors.
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