Horizontal Spread
Candlefocus EditorThe main benefit of a horizontal spread is that it reduces the risks associated with trading options, such as downside risk, volatility risk, and time decay. Such risks are inherent in buying or selling any individual option, and by using the horizontal spread approach, investors can mitigate some of these risks while still pursuing a specific trading strategy.
The idea behind a horizontal spread is to profit from the expected difference between the two options at the two different expiration dates. Generally, the trader will buy the option with the longer expiration in anticipation that it will be worth more by the expiration date than the option with the shorter expiration period. That way, regardless of the price movements of the underlying security, the investor can potentially realize a profit.
The potential profit generated from such a spread is dependent on the actual price difference. The amount of risk involved with a horizontal spread will vary as each trade can differ in terms of variables such as delta, theta, vega, and gamma. Typically, one should focus on the price of the shorter-dated option which is known as the front month.
When using the horizontal spread, it’s important to remember the time value of money and the value of compounding interest. That is, a larger spread (i.e. buying the option with longer expiration) will increase your R-multiple but also require a larger cash outlay while a smaller spread (i.e. buying the option with shorter expiration) will reduce cash outlay but also lower your R-multiple.
There is no one-size-fits-all approach when using horizontal spread techniques. The strategy that best suits each individual trader will depend largely on their unique risk/reward and cost/benefit objectives. Ultimately, what traders should keep in mind is that the goal with a calendar spread is to lock in more profits through both the potential for movement of the underlying asset and the benefit of experiencing time decay.