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How to Trade Horizontal Option Spreads (Part 2)
10/22/2009 12:01 am EST
Horizontal spreads, also known as either calendar spreads or time spreads, are currently one of my favorite strategies to trade. It is my humble belief that during this summer, the US stock market isn't going to do much of anything. The market might go a bit down and up, but overall, at the end of the summer, it will seem as if it did not go anywhere significantly.
I have presented this market bias in one of my previous articles. In fact, it is a well known fact that most of the money made in the stock market is made during the time of October to April. Most of the volume kind of dries up in the market during the summer, and essentially, it becomes very difficult to pick the correct direction. However, if I really "ought to" select one direction over the other, I personally would bring the time component in, meaning the second dimension.
In particular, any given stock chart provides us with 2-D (two dimensions) only, and many traders overemphasize one dimension at the expense of the other. For too many equity traders, the price dimension is more important than the time component. For option traders, both price and time are of the essence. After all, an option is a decaying asset with a predetermined lifespan, as well as a predetermined exercise price.
Hence, if I have to pick a direction, which is, by the way, the single-dimensional concept, then I would bring into my price selection a multiple angle, second-dimension bias. For the duration of the summer, I might choose to be conservatively bearish, while after September, I am inclined to feel somewhat more moderately bullish. Once again, that is bearish for the short term, and bullish for the longer term.
Choosing the Right Strategy
Having openly declared my market outlook, let me now select an option strategy for it. The strategy is very simple, although it has at least three different names: Horizontal, calendar, or time spread. Basically, I first have to buy an option a few months away from the current time, and then I turn around and sell that same option, meaning the very same strike price, for the front month.
The money that I would need to pay out for the back month option would be greater than the premium that I collect for the front month. Therefore, my horizontal spread will end up as a debit trade, meaning that my option brokerage account will be debited in the amount that equals the difference between the bought option premium and the sold option premium.
Once I have opened my horizontal spread position, I will simultaneously hold both an obligation for the front month as well as the right for the back month. A horizontal spread could be done with either calls or puts, yet they both (front and back month) must be the same. Otherwise, it isn't the same strategy. The simultaneous buying of a call and selling of a put at the same strike price would create a synthetic position, and that isn't a horizontal position.
Bullish Call Calendar Spread
The horizontal position that I will describe involves calls, and is basically a bullish call calendar spread. The basic position includes being long a back month call and simultaneously being short the front month call. Both calls at the point of entry could be OTM (out-of-the-money), hence, when the earlier expiry takes place, the front month call will expire worthless while the back month option still has significant premium value due to its extrinsic components, mainly time and implied volatility. The figure below shows the inner premium workings of the contracts:
Again, the aim of this strategy is to have the price first decline in value during the life span of the short options (sold call) and then to see the price increase in value afterwards. Some option traders select the out-of-the-money (OTM) options, yet I have a slight bias to select the at-the-money (ATM) options. They are the most expensive options because the extrinsic value in them tends to be greater than the intrinsic value. The ATM options could, at any given time, become either OTM or ITM (in-the-money), and that is my reason for selecting them in this specific scenario.
However, the described scenario does not have to necessarily happen, and just in case the price starts to rip to the upside, the obligation for the front months needs to be bought back while the back month contract is left open. If the price continues to go even higher, then the long call for the back month will become profitable. Either way, I plan my strategy beforehand and set my alerts as soon as I am in the trade.
In conclusion, I have explained in a bit more detail the inner workings of a horizontal spread trade. Any option strategy has a certain environment that is suitable for it, but the option strategy might fail to work if the environment around it changes. Again, I suggest that one plan the trade as if it will go wrong ahead of time, so if that happens, there is no surprise.
I wish you good trading!
By Josip Causic of OnlineTradingAcademy.com
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