The Horizontal Spread Strategy Explained
A horizontal spread, more commonly known as a calendar spread, is an advanced options or futures strategy. It involves taking simultaneous long and short positions on derivative contracts that pertain to the same underlying asset and carry the same strike price, yet differ in expiration dates.
Key Takeaways
- The horizontal spread involves simultaneous long and short derivative positions on the same underlying asset and strike price but with different expiration dates.
- Horizontal (calendar) spreads allow traders to construct trades that mitigate the effects of time decay.
- Futures spreads utilizing this strategy can capitalize on expected short-term price fluctuations.
- Both options and futures contracts can create leveraged positions.
Mastering Horizontal Spreads
The goal of a horizontal spread is to earn profits from changes in volatility over time or to exploit fluctuations in pricing from short-term events. This spread is often used as a method for creating significant leverage with limited risk.
To construct a horizontal spread, a trader specifies a long position by buying an option or futures contract and simultaneously takes a short position by selling an equivalent contract with a shorter expiration date. The difference in expiration dates creates a price discrepancy known as the time value difference.
In options markets, time value is a crucial pricing component. This spread aims to neutralize the time value expense as much as possible. In futures markets, where time value doesn’t directly influence pricing, the price differences reflect market expectations about future price changes.
Horizontal or calendar spreads are especially prevalent in the options market, where volatility changes have a substantial impact on pricing. This spread minimizes time value effects, providing a potential to profit from volatility increases during the trade.
Short spreads can also be created by reversing the configuration—buying the nearest expiration and selling the distant one—to profit from decreases in volatility.
Practical Example of a Horizontal Spread
Consider the scenario where Exxon Mobil stock trades at $89.05 in late January 2018:
- Sell the February 95 call for $0.97 ($97 for one contract).
- Buy the March 95 call for $2.22 ($222 for one contract).
Net cost (debit) is $1.25 ($125 for one contract) since the trader receives $0.97 and pays $2.22.
Since this is a debit spread, the maximum potential loss is the amount paid upfront—$125. The February option has a lower price due to its nearer expiration date compared to the March option, resulting in a net debit. The trader seeks to capture increased value from a rising price, ideally not exceeding $95 by the February expiration.
The optimal market movement is for the price to rise slightly and volatile, nearing but not exceeding $95 by the February expiry. This allows the February call to expire worthless while profiting from any further upward movements until the March expiry.
Had the trader simply bought the March expiration option, the cost would have been $222. Using the horizontal spread strategy reduced the cost to $125, offering greater margin and reduced risk.
Depending on the chosen strike price and contract type, this strategy can be optimized for various market conditions—neutral, bullish, or bearish.
Related Terms: calendar spread, strike price, volatility, vega, debit spread.
References
- Yahoo Finance. “Exxon Mobil Corporation (XOM)”.
