Saturday, November 12, 2011

How To Enter Spread Positions

Spreads can be great trades, but for most investors they are harder to execute. You should usually use spread limit orders to enter spread positions. Here, you specify the maximum price or debit you wish to pay for a debit spread and the minimum credit or price you wish to receive for a credit spread. A debit spread is a trade where you pay a price to enter the spread, like buying options.

A credit spread is a trade where you receive a premium price when you enter the trade, like writing or selling options. For example, to enter a spread where you buy an XY Oct 80 call at 3 and sell an XY Oct 90 call at 1, you would enter a spread order. Forget about the prices of the options. 

Look at the differences (i.e. 3 – 1 = 2). Here, the difference is 2 points. The spread order would say to buy the XY 80 and sell the XY 90 for a debit of 2 points. The problem with spread orders is that they can be hard to get executed even if the bid and asked prices are in the right place.

On the other hand, the big advantage of the spread order is that you don’t risk losing control of the spread as you add each leg of it. Either you get the spread price you want, or you do not get the trade executed. 

On several occasions set a spread price where was buying at the asked price and selling at the bid price, and though it was a trade that should have been executed automatically because it was a spread order, it wasn’t. The good part is that I never had to worry about losing control if one or the other leg of the trades had gone through, leaving me naked.

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