Opportunities to Use Horizontal Debit Spreads

By Len Yates – President, OptionVue Systems International.

The horizontal debit spread (often called a calendar spread) is a neutral strategy and is a good strategy to use in choppy, sideways markets.  When you can catch the nearby options trading at a higher IV (implied volatility) than the farther out options, you can put on a horizontal debit spread at considerable advantage.

A horizontal debit spread is constructed by selling a nearby option and simultaneously buying a farther out option of the same type and strike price.  The profit diagram for a horizontal debit spread is a broad tent shape, peaking over the strike price (of both options).  (See the illustration below).

Since your best outcome is when the underlying finishes right on the strike price, it is possible to be somewhat bullish or bearish by selecting a strike price slightly away from the current price of the underlying.  For example, with the stock trading at 76, if you are bullish, you might select 80 or 85 for the strike price.

If you are bullish it is probably best to use calls, and if bearish, puts, in order 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 just a nuisance or an important risk.  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.

It is not difficult to find situations where the nearby options are trading at a higher volatility level than the farther out options.  Often a sharp, little sell-off causes this.

For example, in Hanover Compressor (Symbol: HC), the March calls were at 98% while the June calls were at 75%.  This begs the trader to use a horizontal debit spread -- buying the June’s and selling the March's.  A horizontal debit spread may be done at many different strike levels, but with the stock at $14, the strike of choice for the trader expecting a bit of a rebound in the stock would be 17.5 or 20.  The 17.5 spread was available for a price of .75 on Monday February 28, 2002.  See the illustration for a profit diagram of a 10-lot of this spread.

Thanks in part to the extra “kicker” from selling expensive nearby options, this $756 trade has an amazingly broad profit zone.  At the peak (with the underlying at $17.50 in just 47 days), this trade could produce a $2,250 profit.

You can search for good opportunities to use horizontal debit spreads using OpScan*, simply by putting a statement like "IV1-IV2>10" in the pick formula.  This says that the IV of the nearby options minus the IV of the 2nd month options is greater than 10.  At the time of this writing, some of the assets that come up under such a search include Immunex, Washington Mutual, and Dow Chemical. 

However, there is one important caveat:  The trader needs to be aware if there might be some pending news that might move the stock dramatically one way or the other.  Pending news often is the cause of price abnormalities in the options.  Once the news does come out, if it moves the stock up or down a significant amount, this tends to work against an open horizontal debit spread.  However, the horizontal debit spread is sometimes worth doing despite the awareness of pending news, as often times the stock is not moved by the news as much as people think.

*OpScan is a service that allows anyone to scan the universe of listed options for unusual trading opportunities.  For more information, visit www.opscan.com.

Option strategies carry inherent risk of large potential losses. As such, these strategies may not be suited to every investor.