Option trading is remarkably flexible. It can enable you to trade effectively in all kinds of market conditions. But you can only take advantage of this flexibility if you stay open to learning new strategies.
Buying spreads offers a great way to capitalize on different market conditions. When you buy a spread it is also known as a long spread position. All new options traders should familiarize themselves with the possibilities of spreads, so you can begin to recognize the right conditions to use them.
How can you trade more informed?
A long spread is a position made up of two options: the higher-cost option is bought and the lower-cost option is sold. These options are very similar — same underlying security, same expiration date, same number of contracts and same type (both puts or both calls). The two options differ only in their strike price. Long spreads consisting of calls are a bullish position and are known as long call spreads. Long spreads consisting of puts are a bearish position and are known as long put spreads.
With a spread trade, since you bought one option at the same time you sold another, time decay that could hurt one leg may actually help the other. That means the net effect of time decay is somewhat neutralized when you trade spreads, versus buying individual options.
The downside to spreads is that your upside potential is limited. Frankly, only a handful of call buyers actually make sky-high profits on their trades. Most of the time, if the stock hits a certain price, they sell the option anyway. So why not set the sell target when you enter the trade? An example would be to buy the 50-strike call and sell the 55-strike call. That gives you the right to buy the stock at $50, but also obligates you to sell the stock at $55 if the stock trades above that price at expiration.
Even though the maximum potential gain is limited, so is the maximum potential loss. The maximum risk for the 50- 55 long call spread is the amount paid for the 50-strike call, less the amount received for the 55-strike call.
There are two caveats to keep in mind with spread trading. First, because these strategies involve multiple option trades, they incur multiple commissions. Make sure your profit and loss calculations include all commissions as well as other factors like the bid/ask spread. Second, as with any new strategy, you need to know your risks before committing any capital. Here's where you can learn more about long call spreads and long.