Horizontal Spread Explained (Simple Guide)
How would you like to earn a nice return by doing nothing more than letting time increase the value of your position? If so, then you should consider a horizontal spread.
A horizontal spread, or calendar spread, involves buying and selling two options for the same underlying stock at the same strike price but with different expiration dates.
The idea behind the strategy is to take advantage of time decay and changes in volatility. When those two factors move in your favor, you can close out the whole position for a tidy profit.
In this guide, I’ll explain the horizontal spread strategy so you can understand if it has a place in your day-to-day trading.
What Is a Horizontal Spread?
A horizontal spread is an options strategy that involves buying and selling options at the same time.
Why would you want to do that? So that you can hedge yourself against catastrophic losses.
In a typical horizontal spread, you’ll sell a near-term option while buying a long term option. That transaction results in a debit to your account (in other words, it costs money).
In that case, the amount you pay for the whole transaction is your maximum loss. Even if the underlying stock goes all the way down to 0 or doubles in price, you can’t lose any more than the amount you paid for the horizontal spread.
So you know what you’re risking right up front.
A horizontal spread stands in contrast to a vertical spread. When you open a vertical spread, you’re buying and selling options for the same underlying stock with the same expiration date but at different strike prices.
Read Also: What is a protective put?
When Would You Use a Horizontal Spread?
The return of a horizontal spread is based on volatility.
Volatility is the statistical measure of the change in a stock price over time. Stock prices that swing wildly (one way or the other) are said to be volatile. Stock prices that stay relatively flat lack volatility.
If you open a long horizontal spread, then you’ll make money with increased volatility in the underlying stock. Conversely, if you open a short horizontal spread, you’ll make money with decreased volatility.
A long horizontal spread involves selling the near-term option and buying a long-term option. A short horizontal spread involves buying the near-term option and selling the long-term option.
If you think a specific stock is going to become more volatile over time, open a long horizontal spread. On the other hand, if you’re looking at a stock that’s very volatile right now and you think it will decrease in volatility over time, open a short horizontal spread.
How Does a Horizontal Spread Work?
For starters, make sure that your trading platform supports multi-leg orders. You’ll need to enter both options orders at once when you enter into a horizontal spread.
If you plan on opening a long horizontal spread, start by selling the near-term option first. That will give you a credit.
Then, buy the long-term option. Since the long -term option will cost more than the credit you received from the sale of the near-term option, the whole transaction will result in a net debit to your account.
That debit is your maximum loss.
Make sure that you buy and sell the same quantities of contracts for both orders. Otherwise, you won’t be properly hedged.
Also, use the same underlying stock and the same strike price for both orders. The only thing that should be different is the expiration date.
Real Life Example Using a Horizontal Spread?
Let’s say Intel is trading at $46 per share. Its earnings report is just around the corner, so you think the stock will spike in volatility over time.
You sell next month’s $46 call for $1.35. That means you earn $135 because options are traded in blocks of 100 shares ($1.35 x 100).
You buy the following month’s $46 call for $1.78. That costs you $178 ($1.78 x 100).
So your total debit for the whole transaction is $43 ($178 – $135). That debit is your maximum loss.
As expected, the stock becomes more volatile as the company nears its earnings report. Speculative investors move on the stock and shift the price around.
That increase in volatility boost the value of the long-term option because it has a higher vega.
If you’re unfamiliar with vega, it measures the sensitivity of an option’s price to implied volatility (IV).
Let’s assume the positive change in IV raises your long-term call option in value from $178 to $200.
As your long-term option increases in value, your short-term option position will also increase in value. That’s because time-decay reduces its price.
Remember, you sold that near-term option, so you want the price to drop. That’s how you make money.
Let’s assume that your near-term option decreases in value to $75.
Now, you can close out the whole trade for a profit. Buy back the short-term option for $75 and sell the long-term option for $200. That gives you a $125 credit.
You just turned a $43 investment into $125. That’s a nice return for a month’s work!
What Are Similar Strategies Related to Horizontal Spread?
Here are a few strategies similar to a horizontal spread:
- Call Calendar Spread – A horizontal spread that involves using call options that are at-the-money or slightly out-of-the-money.
- Bull Calendar Spread – A long horizontal spread in which the investor “rides out” the long-term option after the near-term option has expired.
- Neutral Calendar Spread – A horizontal spread in which the investor intends to earn money from time decay.
Horizontal Spread Compared to Other Options Strategies?
A horizontal spread earns you money from changes in volatility. Other options strategies, such as the long call, rely on changes in the underlying stock price.
Also, a horizontal spread can put cash in your pocket with time decay. With other options strategies, such as the long put, time decay works against you.
Advantages & Risks of Horizontal Spread?
- Limited risk – Even if the underlying stock swings wildly in one direction or the other, you’re hedged with a horizontal spread. As a result, your loss is limited.
- Time decay works in your favor – When you sell an option, time decay works in your favor. That’s because you earn money as the price of the option decreases. All horizontal spreads involve at least one sale of an option.
- Significant loss – Although the risk is limited, that’s not to say there’s no risk. You can rack up some significant losses if you open several losing horizontal spreads in a row.
- Short-term strategy – As a rule of thumb, it’s ideal if this strategy “wins” in the short-term. For that to happen, volatility has to work in your favor quickly. You might not have time to recover if it doesn’t.