By Josip Causic, Online Trading Academy Options Instructor

Prior to discussing the actual horizontal strategy, we need to review the elementary concepts of buying and selling options. First of all, buying a call, commonly marked by the floor traders as simply a positive "C" (+C) or selling a put (- P) are both bullish strategies. Similarly, buying a put (+ P) or selling a call (- C) are both bearish strategies. Figure 1 illustrates that point by using a gross oversimplification.

The component which is missing from this generalization is the risk to reward profile. If we are long either a call or a put, then our risk is limited to the amount we have invested in going long (the premium price plus commission). In other words, the risk on the long position regardless of whether it is a call or a put does not change (it is the full amount of the premium paid with commissions), yet the reward part on the calls is different from the reward for the puts. The reward in the example of a call is unlimited or infinite, as the price can go up to the moon figuratively speaking; for the reward on the puts the situation is different. The puts could go down only to zero, or the price can drop only to zero, and can never go into a negative territory below zero.

Having covered the basics, let us turn our attention towards Horizontals, which are also known as Time or Calendar spread trades. A horizontal spread is basically a time decay strategy. A note of clarification, it does not matter whether we are trading calls or puts horizontally, but both of the strike prices must be the same kind, either calls or puts.

A horizontal spread trade could be either sold or bought. If we had sold a horizontal spread trade, we need to have a large account size, but if we are long on a horizontal play, then we just need to have enough in our account to pay for the cost of the debit of our horizontal trade. Also, we do not have any maintenance requirement placed upon us by our broker on the horizontal play. The reason for it is that we are not exposing our broker to the risk, for we do have the ownership of the underlying that we are selling.

A long Horizontal involves buying the back (or longer-term) month and selling the front (or near-term) month of the same strike price after we have completed our technical analysis and come up with the clear goal for our trade. For instance, we might expect the price to decline on the December Quarterly options, due to the holidays and low volume. In that case we cannot just simply sell something naked but we do need to own something before we could sell it. Therefore, our first goal should be to buy to open (BTO) Jan 35call and then sell to open (STO) Dec5 35call (number 5 after DEC represents the fifth week of December being the expiry).

The premium for the back month is ALWAYS larger than the premium for the front month. Observe that I have used an absolute term which completely goes against my teaching that nothing is absolute in the stock market. One might wonder whether there was a case that the premium for the front month was more costly than the premium for the back month. Yes! I am going to give a RARE example when such was the case. On the day of the 1987 Crash, the premiums for the front month were priced at the cost that was either equal or even greater in value than the premium for the back month. This rare occurrence is called Horizontal Skew and it does not happen very often, but only in extreme circumstances. Therefore, I must re-emphasize the point that in the stock market arena, there are seldom absolutes.

Due to the larger premium for the back month, we do end up with a debit which comes from our account when we enter a horizontal spread trade. Generally, the IV (implied volatility) is higher for the back month than for the near or front month. A simple reason for that is there is more uncertainty the further away we go from the present.

Once again, a horizontal trade is not a type of trade that we place it and forget about it. We do need to monitor it, and when it works out the way we had anticipated, we still have two choices. Let us assume that we had sold DEC5 35call and at the end of the year the product which we had traded has closed well below 35. In such a case we do not buy back our obligation (sold DEC5 35call) because it will expire worthless. At that point we could either decide to close our long Jan 35call or hold on to it, if our technical analysis tells us that we are about to go higher.

In conclusion, when trading options whether they are horizontal or not, we always have options within options.

- Josip Causic

jcausic@tradingacademy.com

DISCLAIMER:
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results.

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