Very simply, a spread is a position in which options are bought and other options are sold. Having said that, there are dozens of ways to combine options to create simple or exotic trading positions.
Remember that I said options let you move out of the one-dimensional trading world. When you combine the four types of options (long calls, short calls, long puts, and short puts) in various combinations and ratios, you can create a variety of bullish, bearish, or neutral trades that allow you to profit in any type of market condition.
Why would I want to put on a spread?
There are many advantages to option spreads.
Your risk is clearly defined, as when you buy an option. You cannot lose more than a predefined amount. You can get out of the spread and cut your losses, i.e. you do not HAVE to lose the entire predefined amount.
Your returns are typically in the 75% to 150% range. You stand to make significantly better returns with spreads than you do by buying stock.
You can choose your own breakeven price for the stock. You can "engineer" a spread for prices much more favorable than the current stock price, although you will have to settle for a smaller return. You can make a trade-off between return on investment versus probability of profit. Options allow you to trade in a way that suits your style and outlook.
There are a few disadvantages to option spreads:
The biggest disadvantage to an option spread is the time factor. Options, and therefore option spreads, expire. If the stock doesn't do what you hope it does by expiration date, your position expires. With a stock, you can always hold on and hope things pan out next week. With an option, that is not, er, an option.
Commissions are higher for options. Your average stock trade, buy and sell, with an online broker, will be about $40. Option commissions are usually higher, say $30 per trade, and you are doing twice as many trades, since you are buying one and selling another. So your commissions will be in the $120 area.
Multiple bid/ask spreads. The Bid/Ask spread is a factor when buying options, as well as stocks. Sometimes its worse for options. And you have to battle the spread twice, since you are buying one and selling one. It is possible, however, to mitigate this when you place the order by placing spread trades, as opposed to "legging in" by doing your buy and your sell as separate trades.
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