What is a Horizontal Spread?
A horizontal spread is a trading strategy in finance where an investor simultaneously buys and sells options contracts with the same expiration date but different strike prices on the same underlying asset. This strategy is utilized by traders to profit from changes in the price of the underlying asset while managing risk through offsetting positions.
Understanding Horizontal Spread
In a horizontal spread, the key elements to consider are the expiration date and strike prices of the options contracts:
- Expiration Date: All options involved in a horizontal spread have the same expiration date. This means that the contracts expire on the same day, regardless of their strike prices.
- Strike Prices: The options contracts bought and sold in a horizontal spread have different strike prices. The strike price is the price at which the option holder can buy or sell the underlying asset if they choose to exercise the option.
Types of Horizontal Spreads
There are two main types of horizontal spreads:
- Bullish Horizontal Spread: In a bullish horizontal spread, the investor expects the price of the underlying asset to increase moderately over time. To implement this strategy, the investor sells an out-of-the-money (OTM) option with a lower strike price and simultaneously buys an in-the-money (ITM) option with a higher strike price. This allows the investor to profit from the price difference between the two options as the underlying asset’s price rises.
- Bearish Horizontal Spread: Conversely, in a bearish horizontal spread, the investor anticipates that the price of the underlying asset will decrease moderately over time. To execute this strategy, the investor sells an ITM option with a higher strike price and buys an OTM option with a lower strike price. As the price of the underlying asset declines, the investor profits from the price differential between the two options.
Example of Horizontal Spread
Let’s consider an example of a bullish horizontal spread using options contracts on Company XYZ stock:
- Current price of Company XYZ stock: $50 per share
- Expiration date of options contracts: July 1, 2024
- Sell an Out-of-the-Money (OTM) Call Option: The investor sells one call option with a strike price of $55 for $2 per share.
- Buy an In-the-Money (ITM) Call Option: Simultaneously, the investor buys one call option with a strike price of $45 for $8 per share.
In this scenario, the investor is betting that the price of Company XYZ stock will increase moderately but remain below $55 by the expiration date. If the stock price rises to $55 or higher, the sold call option will be exercised, but the investor will still profit from the difference in premium between the two options. If the stock price remains below $55, both options will expire worthless, and the investor will keep the net premium received from the trade.
Conclusion
Horizontal spreads are versatile trading strategies that allow investors to capitalize on moderate price movements in the underlying asset while managing risk through offsetting positions. By understanding the mechanics of horizontal spreads and how to implement them effectively, traders can potentially enhance their overall returns and achieve their financial objectives.
Reference:
- Khan Academy. (n.d.). “Horizontal and vertical spreads.” Options trading strategies. Link