A spread is a term used in the financial world to describe the difference between two security or commodity prices. In the context of trading, it usually refers to the buying and selling of two different contracts for the same underlying security or commodity.
Spreads can be used as part of a trading strategy to take advantage of price discrepancies between markets or hedge risk. Traders can also use them to generate income through options trading.
When trading stocks and other financial instruments, you may at times find it advantageous to use spreads. A spread is simply the purchase of one financial instrument and the sale of another financial instrument. For example, if you believe that the price of a specific stock will go up, you might buy that stock and sell a call option on that stock.
The three main types of spreads
Here are the three main types of spreads traders and investors use in their trading strategy.
The horizontal spread
The horizontal spread involves buying and selling contracts with the same expiration date but different strike prices. Traders can enter into a horizontal spread by buying contracts with one strike price and selling contracts with another. A trader would do this if they expected the security or commodity to move upwards but slower than usual. This strategy helps you take advantage of time decay because it allows you to hold onto the position for longer without having to pay for any extraneous options.
The vertical spread
The vertical spread involves buying and selling contracts with the same strike price but different expiration dates. Traders can enter into a vertical spread by buying contracts with one expiration date and selling contracts with another. A trader would do this if they expected the security or commodity to remain stable over a given period because it eliminates their risk exposure for that specific period. This strategy helps reduce your cost basis because you buy the contract at a lower price and sell it for a higher price.
The diagonal spread
The diagonal spread is a combination of horizontal and vertical spreads. A diagonal spread is used when a trader expects the security or commodity to move in a specific direction but not immediately. They can use this strategy by simultaneously entering into a vertical spread and horizontal spread with different expiration dates and strike prices. This way, they have limited risk exposure over multiple periods while still having the opportunity to profit from any upwards movement of the underlying security or commodity.
Tips to help you get started
Traders can use a spread in many different ways, but some general tips can help you get started.
Have a plan
The first thing to remember when using a spread is that you need to have a plan. Know what you are trying to achieve with your spread trade, and make sure that all of your trades support that goal.
Use a stop-loss strategy
Another important tip is always to have a stop-loss strategy. This is especially important when using spreads because you allow your trade to take more than one possible direction. In addition, always have a maximum risk for each of your spread trades. This should be made clear from the beginning, and you must stick to that maximum risk.
Finally, keep in mind that it can often take some time for a spread’s investment to reach a profit point. Because of this, don’t purchase all of your spreads at once. Instead, invest in them gradually as opportunities arise.
Spreads can be used as part of an options trading strategy because they allow you to benefit from time decay and limited risk exposure simultaneously. But even those knowledgeable about trading must heed those tips if they want success with their Singapore stock market trading strategies. Want to know what is a spread? We recommend you contact a reputable online broker from Saxo to open a demo forex account Singapore for the best advice, lowest commission and excellent customer service.
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