Horizontal (or Do You Say Calendar or Time) Spreads

A horizontal spread, or what it is sometimes referred to as a calendar spread or time spread, is a pretty simple strategy. The spread is designed to work somewhat like a covered call but without the initial outlay of cash that can accompany buying shares of stock. The spread profits from option time decay and can make money in any direction depending on the strikes that are chosen. The spread can be set-up to be bullish, bearish or neutral depending on the outlook of the underlying stock.

Creating a calendar (or horizontal) spread involves buying and selling options on the same underlying with the same strikes but different expiration months. Best case-scenario the stock will finish at the strike price (at expiration of the shorter term option sold) allowing the short-term option to expire worthless and still have the long option retain much of its value.

Example

For the sake of this example, close to At-The-Money (ATM) options will be used but farther Out-of-The-Money (OTM) or In-The-Money (ITM) could also be used depending if there is a bullish or bearish bias.

XYZ stock is currently trading at $64 and has been trading in a tight range for some time now. The trader thinks that it will probably still be about the same price for the next 6-weeks, but is a little more bullish longer-term. It’s the beginning of August and the stock has September and November expiration months available. The trader can buy the November 65 call for 4.75 and sell the September 65 call for 2.75. Since this trade is a debit spread, the most that can be lost on the trade is 2.00 (4.75 – 2.75) in a worst-case scenario. The 65 strike price is close to ATM, being one point above the current stock price.

If the stock remains relatively flat as September expiration approaches, the spread’s value should increase. Why? Because both options lose value as time passes. But the shorter-term option (in this case, September) will lose value at a faster rate. Thus, the net value of the spread increases. Hypothetically, with three weeks left until September expiration the November 65 call might be worth 3.75 and the September 65 call might drop to 0.75. In this case, the spread now would be worth 3.00. If the positions were closed, a profit could now be made of $1.00. If the position were held until after September expiration and the forcast was still short-term neutral, could one sell the October 65 call? Absolutely.

The whole key to the success of the horizontal debit spread is the stock must not have huge price swings. If the stock falls more than anticipated, the spread’s value will decline along with the stock as both calls lose most of their value. If the stock rises well above $65, losses on the short September 65 call will more than offset increases on the long November 65 call, again, leading to a loss.

The beauty of the horizontal debit spread is that it almost functions like a credit spread without the added risk. But like most successful option strategies, the trader still has to be correct on the stock’s outlook.

Dan Passarelli

dan@markettaker.com