What is Horizontal Spread?
Horizontal spreads can be either bullish or bearish, depending on the direction in which the trader expects the underlying asset to move. A bullish horizontal spread involves buying a lower strike price option and selling a higher strike price option, while a bearish horizontal spread involves buying a higher strike price option and selling a lower strike price option.
Mechanics of Horizontal Spread
When executing a horizontal spread, the trader pays a net debit for the spread. The cost of the spread is determined by the difference in premiums between the two options. The trader’s maximum profit is limited to the difference in strike prices minus the net debit paid, while the maximum loss is limited to the net debit paid.
The time decay of options is a critical factor in horizontal spreads. The option with the higher strike price will generally have a higher premium due to its potential for a larger profit. However, it will also experience faster time decay compared to the option with the lower strike price. This time decay differential is what the trader aims to exploit.
Real-Life Example of Horizontal Spread
Let’s say a trader believes that a stock, currently trading at $100, will remain relatively stable over the next month. The trader decides to execute a bullish horizontal spread by buying a call option with a strike price of $95 and selling a call option with a strike price of $105. Both options have the same expiration date, one month from now.
The trader pays a net debit of $2 for the spread. If the stock remains below $95 at expiration, both options will expire worthless, and the trader will lose the $2 paid for the spread. If the stock rises above $105 at expiration, the trader’s maximum profit will be $8, which is the difference in strike prices minus the net debit paid.
| Option | Strike Price | Premium |
|---|---|---|
| Buy Call | $95 | $4 |
| Sell Call | $105 | $2 |
Mechanics of Horizontal Spread
The mechanics of a horizontal spread involve selecting two options contracts, one to buy and one to sell. The options contracts must have the same underlying asset and expiration date, but different strike prices.
There are two main types of horizontal spreads: the horizontal call spread and the horizontal put spread. In a horizontal call spread, the trader buys a lower strike price call option and sells a higher strike price call option. This strategy is used when the trader expects the price of the underlying asset to remain relatively stable or decrease slightly. In a horizontal put spread, the trader buys a higher strike price put option and sells a lower strike price put option. This strategy is used when the trader expects the price of the underlying asset to remain relatively stable or increase slightly.
The goal of a horizontal spread is to profit from the difference in premiums between the options contracts. When the trader buys the lower strike price option and sells the higher strike price option, they receive a premium for selling the option, which helps offset the cost of buying the option. If the price of the underlying asset remains within a certain range at expiration, the trader can profit from the difference in premiums.
For example, let’s say a trader believes that the price of a stock will remain relatively stable over the next month. They could enter into a horizontal spread by buying a call option with a strike price of $50 and selling a call option with a strike price of $55. If the premium received for selling the higher strike price option is greater than the premium paid for buying the lower strike price option, the trader can profit if the price of the stock remains between $50 and $55 at expiration.
Real-Life Example of Horizontal Spread
Let’s consider a real-life example to better understand how a horizontal spread works in practice.
Company XYZ
Suppose we have a fictional company called XYZ, which is a technology company that manufactures smartphones. The company’s stock is currently trading at $100 per share.
Market Outlook
Based on market analysis and expert opinions, it is predicted that the smartphone industry will experience significant growth in the next few months. This positive market outlook creates an opportunity for investors to potentially profit from XYZ’s stock.
Options Strategy
An investor believes that XYZ’s stock price will increase but wants to limit their downside risk. They decide to implement a horizontal spread strategy using options.
The investor buys a call option with a strike price of $105 and an expiration date three months from now. They also sell a call option with a strike price of $110 and the same expiration date.
By buying the lower strike call option and selling the higher strike call option, the investor creates a horizontal spread.
Profit Potential
If XYZ’s stock price increases to $110 or higher by the expiration date, the investor will profit from the options strategy. They will exercise their lower strike call option and sell the stock at $105, while the higher strike call option they sold will expire worthless.
Risk Management
If XYZ’s stock price does not increase or even decreases, the investor’s risk is limited. The maximum loss they can incur is the initial cost of the options.
Conclusion
Emily Bibb simplifies finance through bestselling books and articles, bridging complex concepts for everyday understanding. Engaging audiences via social media, she shares insights for financial success. Active in seminars and philanthropy, Bibb aims to create a more financially informed society, driven by her passion for empowering others.