What is Horizontal Spread?
A horizontal spread is a type of options spread that involves buying the same underlying stocks at the same price, but with different expiration duration. The strategy helps the trader earn a profit from the price fluctuation of short-term events or the changes in volatility over time. It is achieved by buying options in the long term and selling them in the near term.
The transaction creates a debit in the trader’s account, and it means that the money paid for the transaction is the maximum loss. The trader cannot incur additional losses even if the price of the underlying stock increases double fold or decreases to zero.
With horizontal spreads, the trader is aware of the level of risk involved in the trade from the start. Unlike a horizontal spread, a vertical spread involves buying the same underlying asset at the same price with different prices.
- A horizontal spread is an options trading strategy that involves buying the same underlying asset at the same price but with a different expiration date.
- The strategy offers profits from changes in the volatility of the price of the underlying stock from short-term events.
- The trader profits from price volatility or price fluctuations of short-term events.
How It Works
When creating a horizontal spread, first ensure that the trading platform allows multi-leg orders. Start by identifying the options contract to buy, and sell a similar contract but with a different expiration date. The two options contracts share similar characteristics, and they are only separated by their expiration date. The contracts create a difference in time, which is accounted for as time value, which is the time difference between the two contracts.
Since volatility and time value are highly connected in options pricing, the horizontal spreads minimize the effect of time, and it provides an opportunity to gain from the increased volatility over time. A short spread is created by buying in the near term and selling in the long term. The strategy helps traders profit from decreased volatility – long-term trade exploits short-term and long-term options when time value and volatility change.
When to Use Horizontal Spread
The returns of a horizontal spread are based on volatility. Volatility measures the change in the stock price over time. The stock price is said to be highly volatile if there are wild price movements. If the stock price stays close to the same price over a period of time, it is said to lack volatility.
If a trader opens a short horizontal spread, they will earn a return with decreased volatility. Therefore, the trader is said to buy in the short term, and sell the stock in the distant future. In the long horizontal spread, the trader will earn a return with increased volatility in the stock price.
Longer-term options serve to offset losses if the stock price breaks out strongly. For example, if the price of the underlying stock changes suddenly in a horizontal spread, the losses from the short-term options will offset the gain in the long-term option. Similarly, if the stock price breaks out strongly in the other direction, the gains earned in the short-term options may not be adequate to cover the loss in the long-term option, and it may result in a net loss.
Types of Horizontal Spread
Horizontal spreads stem from the difference in time expiration between short-term options and long-term options. It explains why horizontal spreads are sometimes referred to as calendar spreads.
The main types of horizontal spreads include:
1. Call Horizontal Spreads
Call horizontal spreads is a neutral strategy where the trader gains when the price of the underlying asset remains stagnant. The trader gains with the time decay between the near-term and the distant-term options. The strategy utilizes call options; it is sometimes known as a calendar call spread.
2. Put Horizontal Spreads
Put horizontal spreads is also a neutral options strategy that gains when the price of the underlying asset remains stagnant or decreases by a small margin. The strategy uses put options, and it is sometimes known as calendar put spread.
Benefits of Horizontal Spread
- Time decay: Time decay favors the trader when selling an option. Short-term options come with a higher time decay compared to long-term options, and it results in a positive return for the trade.
- Reduced risk: A horizontal spread involves buying options in the long term and selling them in the short term. It creates a debit, and the money paid is the maximum loss. Even if the price of the underlying stock doubles or goes down to zero, the trader cannot incur any more losses. Therefore, the trader’s loss is limited.
Drawback of Horizontal Spread
Higher commissions: The trader incurs increased commissions due to the extra trade activities of buying and writing options contracts.
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