The traditional stock transaction is simple, at least on paper: buy low, sell high. If you’re a short seller it’s only a little more complex: sell high, borrow what you’ve just sold, then buy in later at a lower price and give it back to the lender.
From that basic theory springs hundreds of strategies to make money, sometimes in either direction of price movement. This is where the spread trade comes into play, and it can take several forms.
Spread Trades – Defined
A spread trade is a strategy that takes a position on both sides of a stock or option contract. In theory, if the stock moves in either direction to an extent that the increase or decrease exceeds the spread between the initial positions, the investor makes money.
Here’s an example in the purest sense. You buy 100 shares of XYZ at $20. Then you sell 100 shares of XYZ short. With stock, any movement results in a wash – the gain in one position is directly countered by the loss in another.
Taking Stock of your Options, and Options on your Stock
But when you do the same with an options contract, your loss is limited to the amount of the option side that didn’t work, while the upside of the other is virtually unlimited. This, of course – as it does with stocks – assumes the investor sells the bad trade out before the loss goes too far, allowing the winning side to make a run.
In essence, it’s betting on both directions at once, then waiting to see which way things go. If you bail on the losing side soon enough, then you keep the winner and take the ride for what it’s worth.
Spreading the Wealth, and the Risk
This strategy can get extremely complicated by combining various levels of strike prices, contract lengths and writing strategies, naked and otherwise.
With stocks, the spread trade is a hedging device. With options, it’s a sophisticated strategy designed to gain market leverage in either direction. Spread trades are more common in the commodities business, where product delivery and acceptance become part of the equation, with spreads becoming an element of manipulating that variable in addition to the inherent price swings.
In either case, it’s a game best left to the experienced. Because the action here is fast, the risks enormous, and the potential losses every bit as likely as the possible gains.