What is a horizontal spread?
Horizontal spread is simultaneously long and short positions in derivatives with the same underlying asset and strike price but separate expiry months.
Understanding Horizontal Spread
Horizontal spreads aim to profit from volatility or short-term price fluctuations. The spread can potentially create high leverage with low risk.
A trader buys an option or futures contract and sells one with a shorter expiration date to establish the horizontal spread. The market accounts for the price difference between two identical contracts, separated only by their expiration date, as a time value.
This distinction is crucial in options markets since time value determines contract pricing. This spread minimizes that temporal value’s cost.
The price difference between two expiry dates in futures markets, when time value is not a factor, shows market participants’ expectations of pricing change.
Although horizontal or calendar spreads are typical in the futures market, most studies focus on the options market, where volatility variations significantly impact price. Because option price and volatility are closely related, this spread decreases the influence of time and improves the possibility of benefiting from volatility spikes over the transaction.
Reversing the setup (buying the contract nearer expiration and selling it farther away) creates short spreads. This version capitalizes on volatility reductions.
The long trade exploits time and volatility changes in near- and long-dated options. An increase in implied volatility benefits this approach, as longer-term options are more sensitive to volatility fluctuations (greater vega). The two options may trade at different implied volatility measurements, although volatility and the horizontal option spread price seldom behave differently.
Horizontal Spread Example
Exxon Mobil shares traded at $89.05 in late January 2018.
- One contract for the February 95 call costs $0.97.
- One contract for the March 95 call costs $222.
The debit cost was $1.25 ($125 per contract). The trader gets $0.97 for $2.22.
As it is a debit spread, the maximum loss is the strategy cost. A net negative, or cost, results from selling an option closer to expiration at a lower price than buying it. The trader hopes to profit from a price gain of up to $95, but not beyond, between purchase and February expiry.
The best market move for profit is for the price to become more erratic but climb, finishing slightly below 95 at February expiry. This lets the February option contract expire worthless and lets the trader profit from upward rises until March.
Using this spread, the trader may make and hold this transaction for $125, a deal with more margin and less risk than if they had bought the March expiration.
Depending on the strike price and contract type, the approach can profit from neutral, bullish, or bearish market trends.
Conclusion
- A horizontal spread involves long and short derivative positions on the same asset and strike price with separate expirations.
- Horizontal (calendar) spreads let traders reduce temporal impacts.
- This method lets futures spreads focus on short-term price changes.
- Leveraged positions exist in options and futures contracts.
