Horizontal spreads, also known as calendar spreads or time spreads, are options trading strategies that involve using options with the same strike price but different expiration dates. These spreads are designed to profit from changes in the implied volatility or time decay of options, rather than changes in the underlying asset’s price. Horizontal spreads can be constructed using either call options or put options.
Here are the two main types of horizontal spreads:
- Calendar Call Spread:
- Involves buying a longer-term call option and simultaneously selling a shorter-term call option with the same strike price.
- The goal is to take advantage of time decay (theta decay) in the options.
- The trader profits if the underlying asset’s price remains relatively stable and the shorter-term option loses value faster than the longer-term option.
Example: Buy an XYZ Company call option with a strike price of $50 and an expiration date in 6 months. Simultaneously, sell an XYZ call option with the same $50 strike price but an expiration date in 1 month.
- Calendar Put Spread:
- Involves buying a longer-term put option and simultaneously selling a shorter-term put option with the same strike price.
- Similar to the calendar call spread, the goal is to profit from time decay.
- The trader profits if the underlying asset’s price remains relatively stable, and the shorter-term put option loses value faster than the longer-term put option.
Example: Buy an ABC Company put option with a strike price of $60 and an expiration date in 9 months. Simultaneously, sell an ABC put option with the same $60 strike price but an expiration date in 3 months.
Key points to understand about horizontal spreads:
- Horizontal spreads profit from the time decay of options (theta decay). They are most profitable when the underlying asset’s price remains close to the strike price of the options.
- The maximum profit is typically achieved if the underlying asset’s price is near the strike price at the expiration of the short-term option.
- The maximum loss is limited to the net cost of entering the spread.
- Changes in implied volatility can also impact the profitability of horizontal spreads. An increase in implied volatility can benefit the position, while a decrease can work against it.
- Traders often use horizontal spreads when they anticipate that implied volatility will increase in the future, as this can potentially boost the value of the longer-term option.
Horizontal spreads are often used for income generation and as a way to hedge existing positions. They are also known for their limited risk compared to outright buying or selling options. However, they require careful consideration of factors such as the timing of entry and exit, implied volatility expectations, and the underlying asset’s price movement. Additionally, transaction costs and fees should be factored into the trading strategy.
