The horizontal debit spread (often called a calendar spread or time spread) is a neutral strategy when constructed using at-the-money options. As such, it is a good strategy to use in a choppy, sideways market. When you can catch the nearby options trading at a higher implied volatility (IV) than the farther out options, you can put on a horizontal debit spread at a considerable advantage.
The horizontal debit spread is constructed by simultaneously selling a nearby option and buying a farther out option of the same type and strike price. The performance graph for a horizontal debit spread is a broad, tent-shaped curve, peaking over the strike price of both options. It is not difficult to find situations where the nearby options are trading at a higher volatility level than the farther out options. A sharp little sell-off often causes this.
At the time of this writing, the nearby options in New River Pharmas (Symbol: NRPH) were trading at an IV (implied volatility) more than 95 percentage points higher than the farther out December options. For example, the October 25 calls were at 211% while the December 25 calls were at 115%. This begs the trader to use a horizontal debit spread – buying the December’s and selling the October’s. With New River Pharmas stock at $25.50, the strike of choice for the slightly bearish trader would be 25. The figure below shows the profit diagram for a 15-lot horizontal spread using the 25 calls.
The best possible outcome is always when the underlying finishes right on the strike price. Therefore, it is possible to be somewhat bullish or bearish by selecting a strike price slightly away from the current price. In the example above, with the stock trading at $25.40, if you are slightly bearish you might select 25 for the strike price.
Thanks in part to the extra “kicker” from selling the expensive nearby options, this $1,380 trade has an amazingly broad profit zone ($13.79 - $44.50). At the peak (with the stock price at $25 just 17 days from now) the trade should produce nearly a $6,800 profit!
When constructing horizontal debit spreads, it is probably best to use calls when you are bullish and puts when you are bearish. That allows you to steer clear of shorting in-the-money options. The problem with shorting in-the-money options is the possibility of early assignment (assuming we’re talking about American style options, which may be exercised at any time by their holder). Early assignment is more likely when short in-the-money options have very little remaining time value.
Depending on the situation, early assignment could either be an important risk or just a nuisance. If early assignment happens with stock puts, you will suddenly be long stock, which, together with your remaining long puts, has almost the same risk/reward profile in the short run as you had before. So there is no urgency to respond. However, if early assignment happens with cash-based index puts, your short leg is suddenly gone (in a cash transaction), leaving you with the long leg by itself, which is highly exposed to market movement.
While a big IV differential gives a substantial theoretical advantage to the horizontal debit spreader, it is important to realize that the differential might be there for a good reason. One reason could be that the stock is in the midst of a big move and no one knows where the stock price might settle. Another reason could be anticipated news.
When looking at placing any trade that takes advantage of substantial differences in IV levels, an option trader always needs to be aware the current, and any pending, news. Important announcements can move a stock price dramatically one way or the other. If the stock moves up or down a significant amount, this tends to hurt a horizontal debit spread. However, they are sometimes worth doing despite the awareness of pending news, as the stock often does not move as much as people expected.