Definition of Horizontal Spread
What is a Horizontal Spread
A horizontal spread, also known as a time spread or a calendar spread, is an important and fundamental option spread strategy that is used in the world of options trading. An investor employing a horizontal spread is operating with options that have identical strike prices but different expiration dates, resulting in a strategic play that takes advantage of an option’s theta, or time decay. Theta, one of the first order Greeks or major Greeks in options trading, represents the rate at which the price of an option contract depreciates over time.
Types of Horizontal Spreads
- Call Calendar Spread: This type of horizontal spread involves the sale of a short-term call option and the purchase of a long-term call option at the same strike price. The strategy profits from a moderate rise in the price of the underlying security and from time decay on the short-term option. The ideal scenario is that the short-term call option expires worthless and the long-term call option retains some of its value.
- Put Calendar Spread: This type of horizontal spread is similar to the call calendar spread but it involves put options. In a put calendar spread, you will sell a short-term put option and purchase a long-term put option at the same strike price. This strategy profits from a moderate decline in the price of the underlying security and from time decay on the short-term option. The ideal outcome is for the short-term put option to expire worthless, allowing the long-term put option to retain some of its value.
When to Use a Horizontal Spread
Both of these strategies are typically neutral, meaning they benefit when the underlying security price remains relatively stable and near the strike price, up until the expiration of the near-term option. If correctly predicted, the near-term option will lose its value at a faster rate than the longer-term option, which would lead to a net gain for the trader. However, it is important to note that a significant movement in the price of the underlying asset can lead to potential losses.
Example of a Horizontal Spread
- Sell a June $50 call option on ABC stock
- Buy a September $50 call option on ABC stock
An options trader sells a $50 call option on ABC stock that expires in June and concurrently purchases a $50 call option on the same ABC stock set to expire in September. The combined transactions create a debit spread, which effectively lowers the trade net cost.
Using the Greeks
Successfully navigating horizontal spreads necessitates diligent management and a thorough understanding of options Greeks, especially delta, gamma, theta and vega. These risk measures are instrumental in determining an option's price sensitivity under various conditions, contributing to an informed trading strategy. Key performance indicators to watch include the underlying asset's price, the time until expiration of the options and the implied volatility.
Naming Origin of the Horizontal Spread
The horizontal spread strategy gets its name from the way these trades look on an options chain. Options are listed by strike price vertically and by expiration date horizontally, so trades involving options with the same strike price but different expiration dates are spread out horizontally.
Final Thoughts on Horizontal Spreads
While the horizontal spread strategy is a powerful tool, it is imperative that investors fully understand the nuances of options trading, including the risks and rewards associated with time decay, strike prices and expiration dates. As with any investment strategy, a comprehensive understanding of these key components can better position investors for success in the dynamic and complex world of options trading.
Glossary of Terms and Phrases
A financial dictionary or glossary is an essential tool to better understand the meaning of a specialized term or phrase. It would obviously make life much easier if everyone spoke the same language and used the same financial terms and phrases but that is not realistic.
We learn new languages to communicate with each other, transact business globally and to appreciate other cultures. Global finance is a specialized language that if understood and mastered, it will provide benefits that help to decrease risk and improve investment returns. Financial literacy is the foundation of developing good investment strategies and sound decision making.