Horizontal Spread: Definition, Mechanics, and Practical Example

A comprehensive guide on Horizontal Spread, including its definition, functioning, and practical example to understand its application in derivative trading.

A Horizontal Spread, also known as a Calendar Spread, is an options trading strategy that involves the simultaneous purchase and sale of two options of the same underlying asset, with the same strike price but with different expiration dates.

How It Works§

Basic Mechanics§

A horizontal spread can be created using either call or put options. The strategy typically involves buying a longer-term option and selling a shorter-term option, both with the same strike price. The objective is to capitalize on the time decay (theta) differential between the two options.

Example Formula with KaTeX: The profit or loss can be represented as:

$$P = V_L(T_2) - V_S(T_1)$$

where:

• $P$ is the profit/loss
• $V_L(T_2)$ is the value of the longer-term option at expiration $T_2$
• $V_S(T_1)$ is the value of the shorter-term option at expiration $T_1$

Types of Horizontal Spreads§

Call Horizontal Spread§

Involves buying and selling call options.

Put Horizontal Spread§

Involves buying and selling put options.

Advantages and Special Considerations§

Time Decay Profitability§

Horizontal spreads are designed to profit from the differing rates of time decay. The value erodes faster from the short-term option, benefiting the trader holding a long-term position.

Implied Volatility Impact§

Changes in implied volatility can affect the spread, potentially making the strategy more or less profitable.

Example§

Consider an investor who believes that the stock price will not move significantly in the short term but might change after the next earnings report. The investor might:

• Buy a January call option (long-term)
• Sell an October call option (short-term)

Both options have the same strike price of $50.

• Suppose the January call costs $3, and the October call sells for $1.50.
• The initial investment is $1.50 ($3 - $1.50).
• If time passes without significant price movement, the October call might decay faster, potentially leaving the January call’s value relatively stable.

Historical Context§

Horizontal spreads have been commonly used since the development of modern options trading in the 1970s, particularly after the establishment of the Chicago Board Options Exchange (CBOE).

Applicability§

This strategy is ideal for traders expecting low volatility in the short term but potential movement in the longer term. It’s also used by more experienced traders to hedge other investments.

Comparisons and Related Terms§

Vertical Spread§

Different from horizontal spreads, vertical spreads involve options with different strike prices but the same expiration date.

Diagonal Spread§

This involves options with different strike prices and different expiration dates, combining aspects of both horizontal and vertical spreads.

FAQs§

1. What is the primary risk in a horizontal spread?

The primary risk is that the trader might misjudge the volatility or timing, leading to losses if the stock price moves sharply in the short term.

2. Can horizontal spreads be used in different market conditions?

Yes, they can be adapted to various expectations about volatility and price movement.

References§

• Hull, J. C. (2017). Options, Futures, and Other Derivatives. Pearson.
• McMillan, L. G. (2004). Options as a Strategic Investment. New York, NY: New York Institute of Finance.

Summary§

A horizontal spread is a nuanced options strategy leveraging time decay and volatility differences between short-term and long-term options. When correctly implemented, it can capitalize on predictable price stability in the short term while maintaining potential for longer-term gains. Understanding the intricacies of this spread can provide traders with a valuable tool in their investment arsenal.