Definition
A horizontal spread is an options trading strategy that involves buying and selling two options of the same type (either two calls or two puts) but with different expiration dates, while the strike price remains the same. It aims to take advantage of the time decay of options and the differences in volatility over time. Horizontal spreads are also commonly known as calendar spreads or time spreads.
Phonetic
The phonetic pronunciation of “Horizontal Spread” would be /hɔːrɪˈzɑːntl̩ spred/.
Key Takeaways
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- Horizontal Spread, also known as a calendar spread, involves buying and selling two options of the same type (calls or puts), same strike price but with different expiration dates.
- These spreads are employed when the trader has a neutral outlook on the market and expects the underlying asset to remain within a tight price range.
- The maximum profit for this strategy is achieved when the price of the underlying asset is equal to the strike price at the expiration date of the short-dated option. But its potential losses are limited if the price moves significantly in any direction.
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Importance
The term Horizontal Spread is significant in business and finance as it pertains to an investment strategy involving the purchase and sale of two options with the same strike price but different expiration dates. It provides the investor the potential to generate profits based on the difference in time decay of the two options. Since options tend to lose their value over time, especially as they approach their expiration date, the horizontal spread can be profitable when the option sold expires first and decreases in value more rapidly than the option purchased. Overall, it’s a tactic that emphasizes the timing of option investments and can be an important part of a diversified investment portfolio.
Explanation
The primary purpose of a horizontal spread, also known as a calendar spread, in finance is to take advantage of the time decay characteristics of options. Traders or investors use this strategy when they anticipate minimal movement in the price of the underlying security over a certain period. It involves simultaneously buying and selling two options of the same type (either both calls or both puts) with the same strike price but different expiration dates, usually with the purchased option expiring later than the sold option, thereby allowing it to hold value longer.A horizontal spread is primarily used for its potential to generate profit from the difference in the rate of time decay between the two options. The basic premise is that as time passes, the value of options decay. However, options with longer time to expiration decay at a slower rate compared to those with nearer expiration dates. If the price of the underlying security remains relatively stable, the option with the earlier expiration will lose value faster, which could potentially result in a net gain for the trader or investor when the difference in premiums is taken into account. It’s a flexible strategy that can be adjusted according to the trader’s forecast, be it bullish, bearish or neutral.
Examples
A horizontal spread, also known as a calendar spread, is an options or futures strategy that involves simultaneously buying and selling two contracts for the same asset with differing delivery months. Here are three real-world examples:1. Oil Trading: A crude oil trader might utilize a horizontal spread to capitalize on the difference between two delivery months. For example, the trader might buy oil futures for delivery in April and simultaneously sell oil futures for delivery in June, hoping that the price for June delivery will be higher than that of April, thus profiting from the difference.2. Agriculture Commodities: Another example could be in the agriculture sector where a farmer anticipates a rise in the price of wheat due to seasonal variations. They could sell short-term wheat futures (e.g. May) and buy long-term contracts (e.g. December). If the price of wheat in December is indeed higher due to the decrease in supply, the farmer would make a profit from this horizontal spread trade.3. Stock Market: A stock trader may use a horizontal spread if they believe a particular stock’s price is going to increase or decrease moderately in the coming months. They could buy an option to sell the stock in six months (put) and sell an option to sell the stock in three months (also put). By doing so, they are limiting their risk, as the worst-case scenario would be having to provide shares at the selling price agreed upon in the shorter-term option, which can be offset by the purchased long-term option.
Frequently Asked Questions(FAQ)
What is a Horizontal Spread?
A horizontal spread, also known as a calendar spread, is an options or futures strategy that involves simultaneously buying and selling two contracts for the same asset with the same strike prices, but with different expiration dates.
Why is it called a Horizontal Spread?
It’s named a ‘horizontal’ spread because of the way the strategy looks on a chart when plotted against expiration dates. The different expiry dates represent a horizontal axis.
What is the aim of a Horizontal Spread strategy?
The aim is primarily to take advantage of the time decay characteristic of trading options. The strategy profits from the faster decay of near-term options in comparison to longer-term options.
Is the Horizontal Spread a high-risk investment strategy?
Although all investment strategies have their inherent risks, the horizontal spread is relatively lower risk compared to other strategies given the offsetting position in two different expiration dates.
Can you make profits with a Horizontal Spread strategy?
Yes, profits can be made with a Horizontal Spread strategy if done correctly. The maximum profit is typically realized if the stock price equals the strike price at the expiration of the near-term option.
When should an investor consider using a Horizontal Spread?
An investor should consider using a Horizontal Spread when they expect minimal movements in the price of the underlying asset in the near term. It’s an excellent strategy in a stable market.
What are the key components of a Horizontal Spread?
The key components are the underlying asset, the strike price of the options, and the expiration dates of the options.
Is a Horizontal Spread suitable for every investor?
As with any trading strategy, it greatly depends on the investor’s risk tolerance, market expectations, and understanding of the strategy itself. It’s always recommended to do due diligence and perhaps seek professional advice before implementing any investment strategy.
Related Finance Terms
- Options Trading
- Time Decay (Theta)
- Strike Price
- Expiration Date
- Implied Volatility
Sources for More Information
