Suppose you think a stock is going to hit a specific price, but this move might take anywhere from six weeks to six months to take effect.
Horizontal spreads are a great option tool when you believe you know the direction a stock will move, but it’s not clear exactly when.
With horizontal spreads (also called “calendar spreads” or “time spreads”), investors write (or “sell to open”) a near-month call or put option and simultaneously purchase (or “buy to open”) a longer-dated option in the same equity and at the same exercise price.
Basically, you’re purchasing an option to hold long, just as you would a stock, and you’re selling another option against it to collect some income while you wait for the stock (by proxy of the option you hold long) to make the anticipated move.
Horizontal spreads allow traders to profit from a change in the price difference in the underlying security as the option moves closer to expiration. You’re buying time, literally, with the option you purchase with the later expiration date — you can buy a LEAP, which is a long-term option that can give you up to two-and-a-half years of time, or else pick something a bit closer — even if it’s a month or two past the expiration date of the short call — if you believe the anticipated move could come sooner.
Meanwhile, by selling the shorter-dated option, you offset the cost of the longer-dated option and aim to ensure that whether the stock moves sooner or later, you’ll be well-within the window to turn a lower-risk profit at any time without all the guesswork that goes into trying to time the trade perfectly.
For example, as Apple (AAPL) increases its market share, you may start looking toward its equipment suppliers as another way to play the company’s success in the PC, laptop and smartphone market. So, let’s look at Broadcom (BRCM), which supplies a touch-screen controller chip for the iPhone, as an example of a potential play.
But suppose you’re not sure whether the effect on Broadcom will be immediate or may need some time to play out.
To potentially profit from either scenario while lowering your risk and necessary capital to make this investment, you might choose to purchase the Broadcom January 22.50 Calls (with an expiration date of January 2010) for a $5 debit and sell the Broadcom November 22.50 Calls for a $3 credit, which would result in a net cost of $2 to initiate the trade. (Please note that this is for illustrative purposes only.)
The January 2010 calls you bought have more time value, with several more months left until expiration and, therefore, a greater chance of working in your favor, than the November calls you sold.
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The time value is the reason they are more expensive as, quite simply, the long calls give you more time for the trade to work in your favor.
By buying $500 worth ($5 times the 100 shares that an options contract represents) of the January and selling $300 worth ($3 times 100 contracts) of the November calls, you would incur a net debit of $200 to initiate this trade (not including commissions).
The calendar spread strategy is similar to a covered call in that your long option serves as a stock surrogate and the writing of calls against it provides you income against that purchase. When those short November options expire, you are still holding those January options long and can sell another set of nearer-term options against them for as long as you believe in this trade.
And if you change your mind about the trade at any time, you can sell to close the January options and buy to close the short options!
Why is this a strategy to add to your trading arsenal, as opposed to simply buying the long option and not doing anything else? Well, for starters, it’s because the short position serves as a hedge. If the stock should unexpectedly drop, that short call would become more-valuable. Additionally, when you write the near-term option, you are using other peoples’ money, so you invest less capital.
Perhaps best of all, horizontal spreads allow you to profit from most investors’ top enemy: time decay. The options you sold short, in this case the November 22.50 Calls, shrink faster in value than what you bought, the January 22.50 Calls with the 2010 expiration date. Your cash outlay is in the gap between them, and widening that gap broadens your profit potential.
But there’s another way to profit from horizontal spreads — by switching to the long position. Let’s say that Broadcom shares climb to the $22.50 strike price before the November expiration. You can buy back the short position and let the long one ride. Many option traders subscribe to the trend theory, which predicts that if the underlying stock breaks through the strike-price barrier — in this case, $22.50 — it will likely continue in that direction.
This augments the long position’s value and, when it happens, some spread traders wait until the underlying stock passes through the strike price and moves in-the-money before they buy back the short leg of the trade. Others close out the short leg when the stock hits the strike price, even though it is not yet in-the-money.
As with all options trading strategies, when to exit a position is often a matter of personal preference, but horizontal spreads can increase the likelihood that, regardless of when you choose to walk away, you’re ensuring that time is always on your side.
