Horizontal Debit Spreads
Len Yates

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.

Horizontal Debit Spread Analyzed

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!
Page: 1 2