Horizontal spread: Meaning, Criticisms & Real-World Uses

What Is Horizontal Spread?

A horizontal spread, also known as a calendar spread or time spread, is an options trading strategy that involves simultaneously buying and selling options contracts of the same type (both calls or both puts) and the same strike price, but with different expiration dates. This strategy falls under the broader category of options trading and is primarily used to profit from the passage of time and differences in implied volatility between the nearer-term and farther-term options. The goal of a horizontal spread is often to capitalize on the faster rate of time decay of the short-term option compared to the long-term option.

History and Origin

The concept of options trading, the foundation for strategies like the horizontal spread, has roots stretching back centuries, with early forms of derivatives contracts seen in ancient Greece and later in Dutch tulip markets. Modern options markets began to formalize in the late 19th and early 20th centuries, but it wasn't until the establishment of the Chicago Board Options Exchange (CBOE) in 1973 that listed options trading became standardized and widely accessible. This marked a pivotal moment for the development of complex strategies. Before this, options were primarily traded over-the-counter. The standardization of terms, strike prices, and expiration cycles allowed traders to easily combine various options contracts to create nuanced strategies like the horizontal spread. The Chicago Mercantile Exchange (CME Group), for instance, has a long history, evolving from the Chicago Butter and Egg Board in 1898 to a global leader in financial derivatives, launching its first financial futures contracts in the 1970s and subsequently expanding its offerings to include a wide array of options⁵. The growth and innovation within these exchanges facilitated the practical application and popularization of multi-leg options strategies, including the horizontal spread.

Key Takeaways

A horizontal spread involves buying and selling options of the same strike price and type but different expiration dates.
The strategy typically profits from the differential in time decay between short-term and long-term options.
It is often employed with a relatively market neutral outlook on the underlying asset's price, or to capitalize on expected future volatility changes.
The maximum profit and loss potential are typically well-defined at the outset of the trade.

Formula and Calculation

The primary calculation for a horizontal spread involves determining the net premium paid or received when establishing the position.

For a debit horizontal spread (e.g., buying a longer-dated option and selling a shorter-dated one):

Net Debit = ( \text{Premium of Long Option} - \text{Premium of Short Option} )

For a credit horizontal spread (less common for traditional calendar spreads, but possible):

Net Credit = ( \text{Premium of Short Option} - \text{Premium of Long Option} )

At expiration date of the short-term option, the profitability of the horizontal spread depends on the value of the long-term option and the expiry of the short-term option. If the short-term option expires worthless, the entire premium received from selling it is retained, reducing the cost basis of the longer-dated option.

Interpreting the Horizontal Spread

Interpreting a horizontal spread primarily revolves around understanding the impact of time decay (theta) and implied volatility (vega) on the options. The core idea is that the closer-dated option loses its extrinsic value at a faster rate than the farther-dated option. Traders typically establish a horizontal spread when they expect the underlying asset's price to remain relatively stable until the short-term option expires, or when they anticipate a rise in implied volatility for the longer-dated option after the near-term option has expired. A net debit spread indicates a cost to establish the position, with the expectation that the longer-dated option's value will increase sufficiently or the near-dated option will expire worthless, making the strategy profitable.

Hypothetical Example

Consider an investor who believes that XYZ stock, currently trading at $100, will remain relatively stable over the next month but expects a significant price movement in the subsequent months. To implement a horizontal spread, they might execute the following:

Sell: One XYZ July 100 call option for a premium of $2.50.
Buy: One XYZ August 100 call option for a premium of $4.00.

The net debit for establishing this horizontal spread is $4.00 - $2.50 = $1.50 (or $150 per contract, as one option contract typically represents 100 shares).

Scenario 1: XYZ remains at $100 by July expiration.
The July 100 call option expires worthless, and the investor keeps the $2.50 premium. The investor now holds only the August 100 call option, which still has time value. If the August 100 call is still worth, say, $3.00, the investor’s total outcome would be ($2.50 received + $3.00 current value of long option) - $4.00 initial cost = $1.50 profit (or $150).

Scenario 2: XYZ rises to $105 by July expiration.
The July 100 call option is in the money and would be exercised. The investor would be obligated to sell shares at $100. The August 100 call option is also in the money. This scenario could lead to a loss if the short call's loss exceeds the long call's gain. This illustrates the typical market neutral or slightly directional nature of the strategy.

Practical Applications

Horizontal spreads are employed by investors seeking to profit from the differential decay of extrinsic value between two options contracts with different expiration dates but the same strike price and underlying asset. A common application is to generate income or reduce the cost of holding a long-term option by selling a near-term option against it. This strategy is also useful for traders who anticipate a period of low volatility in the near term, followed by an increase in volatility later on, benefiting the longer-dated option.

Furthermore, horizontal spreads can be used as a form of hedging strategy, particularly when an investor holds a longer-term position and wishes to reduce its time decay exposure while maintaining exposure to future price movements. The Securities and Exchange Commission (SEC) provides introductory information on options, emphasizing that options are versatile derivative instruments that can be used for both speculation and risk management. ⁴For instance, a Federal Reserve Bank of San Francisco Economic Letter highlights how financial markets, specifically derivatives, contain information about future interest rates, underscoring the role of these instruments in reflecting and managing market expectations.
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Limitations and Criticisms

While horizontal spreads offer distinct advantages, they also come with limitations and criticisms. One significant drawback is their sensitivity to the underlying asset's price movement. If the price moves too far from the chosen strike price by the expiration of the short-term option, the strategy can incur losses. This makes the horizontal spread less effective in highly volatile or trending markets where the underlying asset experiences significant price swings.

Another criticism relates to the complexity involved in managing these positions, especially for novice traders. Factors like changes in implied volatility can significantly impact the profitability, and accurately forecasting these changes is challenging. Moreover, the bid-ask spread on less liquid options can erode potential profits or exacerbate losses. Academic research has explored the challenges in accurately pricing options. For example, a National Bureau of Economic Research (NBER) working paper discusses how implementing option pricing models like the Black-Scholes formula, despite its theoretical robustness, requires careful consideration of empirical factors such as predictable asset returns, which can influence the parameters and ultimately the model's accuracy. ²This suggests that even sophisticated models may not perfectly capture real-world market dynamics, impacting the theoretical edge of options strategies. Another study examined the Black-Scholes model and found that it did not react sufficiently quickly to changes in market volatility during financial turbulences, indicating that models can sometimes overprice options.
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Horizontal Spread vs. Vertical Spread

The primary distinction between a horizontal spread and a vertical spread lies in the variable that differs between the two options contracts.

A horizontal spread (or calendar spread) involves options with the same strike price and the same type (call option or put option), but different expiration dates. The goal is typically to profit from differences in time decay and implied volatility between the nearer-term and farther-term options, often with a market neutral bias. For example, buying a longer-dated 50-strike call and selling a shorter-dated 50-strike call.

Conversely, a vertical spread involves options with the same expiration date and the same type, but different strike prices. Vertical spreads are typically used to profit from a directional move in the underlying asset, whether a bull market or a bear market, within a defined risk and reward profile. For example, buying a 50-strike call and selling a 55-strike call, both expiring in the same month. The confusion often arises because both are multi-leg options strategies, but they exploit different market dynamics.

FAQs

What is the ideal market condition for a horizontal spread?

A horizontal spread generally performs best in a relatively stable or sideways market for the underlying asset, particularly when the short-term option contract is near the strike price at its expiration date. It can also be favorable when a significant increase in future implied volatility is expected for the longer-dated option.

Can a horizontal spread be used for income generation?

Yes, a horizontal spread, particularly a debit calendar spread where the long-dated option is more expensive, can be a way to manage the cost of carrying a longer-term directional view. By selling a short-term option, the premium received can offset some of the cost of the long-term option, effectively generating income if the short-term option expires worthless.

What is the maximum loss on a horizontal spread?

The maximum loss for a debit horizontal spread is typically limited to the net premium paid when initiating the trade, plus any transaction costs. This occurs if the underlying asset moves significantly away from the strike price in either direction, causing both options to expire worthless or to be exercised in an unfavorable way.