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But you might be asking yourself, especially if you’re a total beginner to options, “If the price is $2.40, and we’re only buying one contract, why are we paying $240?”
The reason that we’re paying $240 and not $2.40 is because each contract, and this is true for every single option, except for some exotic European options, or some other options. It’s true for the majority of the stocks or indexes that you’ll be buying – a single option contract actually gives you the right to purchase 100 shares of the underlying stock, up to the expiration date.
One contract is actually equal to 100 shares of stock. When you look at the price of an option – or, in this case, the price of a spread – you would take the $2.40 that you’re paying for the contract, multiply it by $100 to determine what the actual cost of that option, or, in this case, the spread, is.
That’s why we’re paying $240 and not $2.43, or $2.40. That is exactly how you would determine your breakeven points, your profit on this position, your maximum loss, and the cost of the trade.
Remember this cost of $240, plus $3 in commission for $243 total cost. What happens if we try to get this at the mid-price? If we try to get this at the mid-price, which is considered to be wholesale pricing, our maximum profit, now, has jumped from $260 to $280. That’s because our cost of the trade is only $220. If we take the $2.20 and subtract it from the 5 of our vertical spread, now we have a potential profit of $280 on that spread.
Since it’s only costing us $220, our maximum loss is also now $220. With the $3 commission, it’s going to cost us $223. Actually, it saved us by trying to enter this order as a spread, instead of individual orders of the options. It saved us 20 on this one order.
That may not seem like a lot. However, if you enter enough of these orders over a period of a year, that $20 can add up very quickly.
Let’s just give you an example. If you were to put a 10 lot on these, let’s see what the difference in the price is. If we were to enter this at the retail price of $2.40, we would be paying $2,400 plus $30 in commissions, so $2,430. Our maximum profit is $2,600.
If we bought this at the mid-price, we have shaved $200 off the price of our spread. Now, our profit is $2,800. Our maximum loss is only $2,200. Which is the cost of the spread plus the commissions, or $2,230.
You can see that not only does trying to get the mid-price help us save money, it’s really wholesale pricing of the options. Like I said, you’re not always going to get it at the mid-price. You could even shave the difference between the mid-price and the natural price, and try for $2.30, if you couldn’t get it at the mid-price in the beginning. You’d still save quite a bit of money on this. On a 10 lot order, it’s $100 savings, if you can get it cheaper.
Even on a 1 lot order, you could save $10. Those dollars do add up.
That’s a very basic understanding of spread orders, and why we do spread orders. Let me just show you one additional feature and benefit of entering spread orders, instead of individual option orders.
I’m going to go back here. Let’s say we wanted to enter the spread as individual options. We are buying that one. We are selling that one.
When we enter these orders, we have a couple of different options available to us, in our dialogue box. We can “Blast all,” we can have a “1st triggers sequence,” or we can have a “1st triggers all.” If we can purchase this one, then it will trigger the sale of this one.
What happens if the market accepts the order on this price, but it doesn’t accept the order on this one? It accepts the order that we’re buying, but the price moved, after this one was entered. Now we can’t get this one for $1.70. What happens to our spread? Our spread may widen, or it may decrease. We don’t know.
We’re not going to get the other leg of this order in. All of a sudden, instead of paying $2.40 for this order, we may have to pay $2.50 or more for this order. Or the price may go against us, and our long call may be worth less money. We didn’t have the protection of the short call, in order to help offset the loss on this long call.
The calls that we are buying are called long, usually. Long calls, long puts. Those are the ones we are buying. The ones we are selling are called short. They are short the call, or short the put. Those are the ones we are selling. That’s just the terminology that people use, when they’re describing if they’re long a call, or short a call.
You can see that when you put in these type of orders, that if you do them individually, you have more risk than if you put them in as a vertical spread order. You may get a higher price or a lower price if you try to play around with it, but if the market moves dramatically against you, you might get hurt. You might end up paying a lot more for that spread than you should have. Or, the price will move against you, and you’ll lose money.
It’s always best to put these orders in as a spread. You’ll always get the best price, the best execution. You don’t have to pay retail prices, unless the market is not going to be very forgiving. Then you can try to. At least you can always try to get the mid-price or the wholesale price, before you start raising your prices in order to get the position on.
That is a vertical spread. That is a simple vertical spread, where you’re purchasing one call, and selling another.