Spreads: Horizontals

Option Spreads: Horizontal Spreads
Published orginally at Investopedia.com

By John Summa, CTA, PhD, Founder of OptionsNerd.com

When we employ the same strikes in a spread, by definition, it means that we need to use different months, otherwise the trade is an offsetting one (a buy and sell order on the same strike would cancel out). Known as a horizontal spread (going across different months but using the same strikes), the profit/loss dynamics are again fundamentally different from those we saw in the vertical bear and bull call spreads. Figure 1 presents a summary of the key buy-sell combinations that define horizontal spreads, as well as vertical and diagonal (to be covered next) spreads.

Since horizontal spreads involve selling and buying (or buying and selling) options with different rates of time value decay (i.e. the Theta values are not the same on each option in the spread because one option expires before the other), these types of spreads are known as calendar (or time) spreads. Their source of potential profit, therefore, is a differential rate of time value decay on the two option legs in the spread. (For more insight, see The Importance Of Time Value.)

The horizontal time spread is presented usually as a strategy to deploy if you have a neutral outlook on the underlying. Since it profits from differential rates of time value decay, it does not like movement of the underlying. Too much movement of the underlying, in either direction, will result in losses, which are defined always by the size of the debit (purchase price) of the spread. Another important, but often overlooked, dimension to these spreads is the exposure they have to changes in volatility, measured in position Vega.

Recall that position Vega refers to the degree to which the strategy will suffer or gain from a change in volatility. In horizontal time spreads, since you are short the nearby month and long a back month (which could be the next month or farther away month), you will have differential Vega on the options in the spread. That is, the back month option will always have more Vega than the front month because it has more premium. Therefore, if you are buying the back month, you are creating a spread with more long Vega than short Vega, meaning the spread will profit from a rise in volatility. Below you will see that when we reverse these time spreads (buying the nearby and selling the back month), the position Vega is reversed, leaving you exposed to a rise in volatility (and potentially profiting from a fall in volatility).

The position Vega of the horizontal time spread constructed by selling the front month and buying the back month makes these trades problematic for a neutral outlook. If you want the stock to stay in a narrow range, you are unlikely to have an expansion in volatility, which would help this spread from the perspective of the Vega dimension. On the other hand, if you have a rise in the level of volatility, it may help lend a hand in reducing actual risk (and just the opposite when the levels fall). These trades are often excellent short-term position Delta neutral trades to put on to play a quick change in volatility levels, which will produce an immediate profit. This works best at market bottoms. (To learn more, read Capturing Profits With Position-Delta Neutral Trading.)

Continuing with the IBM example, let’s say the stock is trading at 85 and we have a neutral outlook. We could set up a horizontal time spread by selling an ATM call and buying a call option at the same strike in a back month. Let’s say we sell the June 85 and buy the October 85. Keep in mind that the same structure could be applied using puts and it will not affect the outcomes since premiums should be close to parity for the ATMs.

The prices of the options are contained in Figure 2 below. As you can see, the nearby is trading at 1.70 ($170) and the October at 4.20 ($420). Therefore, if we sell the June and buy the October, we pay $200 for the spread, which defines our maximum loss (a concept that will become clearer below). In the same table, the Theta and Vega values have been included to illustrate the points mentioned above.

The cost of this spread would have been $250, or the difference between the purchase of the October 82.5 and sale of the June 82.5. That this represents your maximum loss can be seen easily if you think of the stock falling to zero. If the stock were to go to zero, both options would be worth zero and you would lose $420 on the October (the leg you are long) and gain $170 (the leg you are short) on the June, leaving a loss of -$250, as seen in Figure 3, below. In other words, the spread can go only to zero, always limiting your losses. On the winning side, if the spread narrows, you’ll have the potential to close the trade at a profit. The spread narrows if the nearby month loses value faster than the back month. As you can see in Figure 2, the Theta values are not the same. The June 82.5 is gaining $2.87 per day at present but the October 82.5 is losing just $1.64 per day.

At this differential rate of decay (+$1.23 per day) the position will continue to show unrealized gains provided the underlying stock does not move too far either way, or the levels of volatility don’t change much. Note that the position is position Vega long, meanwhile, with the October gaining +$21.00 for each percentage point rise in volatility, which is offset by a smaller negative Vega of just -$9.83 per point change in volatility. The position Vega, therefore, is +$11.37.

If the spread is projected over about 33 days left in this trade (given that the rate should accelerate), the returns should be approximately $100 if the price of the underlying does not change, as you can see in Figure 3. But this does not factor in volatility changes, if any were to occur.

This is fine if the volatility remains unchanged, and that may take place if the stock hardly moves. But if changes in underlying volatility, or the implied volatility, take place for whatever reason (implied may rise without movement if investors anticipate a big move ahead), the picture gets messy. Again, it would be hurt by a fall in volatility and helped by a rise because this classic horizontal time spread is long Vega. Therefore, this type of trade might work well going into an earnings announcement if you are looking to ride the rise in implied volatility generated by speculative demand in puts and calls ahead of any big announcement. Of course, you would need to get long Vega with a time spread ahead of a rise in implied volatility, and hopefully get out before it dropped again.

In short, the horizontal time spread has profit potential from differential time value decay, but it might be more realistic to use these as long volatility plays. As you will see below, by reversing this trade, you might be able to profit from a fall in implied volatility following the news event that drove up current levels of volatility to above-normal levels (of average volatility). Here you would hope to gain from getting short volatility, which you will see in Figure 4 below, can be accomplished with small risk with a reverse time spread. The reverse time spread simply changes the order of the spread from sell front month to buying front month. And on the back month, you would reverse it from being long to short. As you can see in Figure 4, the position Vega is now negative, meaning it will profit from a fall in volatility. But the trade is not exposed to a negative position Theta, meaning it loses from time value decay.

To finish with the non-reversed example of IBM horizontal spread, Figure 3 shows the maximum profit potential of this type of trade (abstracting from volatility changes). For example, if IBM settles right at 82.5 on the third Friday of June (the month of the call option we sold), we keep the entire premium collected from the sale of that option. Meanwhile, the October 82.5 call would be liquidated at that point, taking a loss. But the loss would be smaller than the gain from the sale of the June call, leaving our maximum profit. As you move higher or lower, the potential for profit declines and eventually poses potential losses, as seen in Figure 3. The spread, in this case, does not widen and instead narrows, leaving potential losses. This occurs in either an up or down market because the position Delta dynamics swamp the potential for a differential rate of time value decay to provide a profit. However, keep in mind that a very small rise in volatility can improve dramatically the prospects for profit here (not captured in this diagram).

Let’s take a look again at reversing this spread. It should be clear by now that when we reverse this horizontal time spread, the position Greeks reverse as well. So the position becomes position Theta negative (you are losing with time value decay) and position Vega negative (meaning a potential to win with a fall in volatility). Clearly, this would mean that this trade requires an entirely new set of conditions for potential profit. In short, you would want to put this trade on if you expected the market to make an explosive move with an associated fall in volatility (implied). Typically, this occurs at market bottoms in equities as fear subsides and premiums fall on options when the stock reverses. As can be seen in Figure 5, the maximum profit can be found at the extremes of price movement, otherwise time value decay will produce a loss on the purchased nearby option that is greater than any potential gains on the back month sold option.

Go to Part 7
Option Spreads: Diagonal Spread