Opportunities To Use Horizontal Debit Spreads
The horizontal debit spread is a neutral strategy. 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 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 Figure 1.)
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 selloff causes this.
In a recent tech stock selloff, there was a time when the nearby options were trading at 10+ percentage points higher IV (implied volatility) than the farther out options. For example, in JDS Uniphase
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PowerRating), the August calls were at 94% while the September calls were at 81%. This begs the trader to use a horizontal debit spread — buying the September’s and selling the August’s. A horizontal debit spread may be done at many different strike levels, but with the stock at ~130, the strike of choice for the trader expecting a bit of a rebound in the tech stocks would be 135 or 140. The 135 spread was available for a price of 3 5/8 on Tuesday July 25, 2000. See the illustration for a profit diagram of a 10-lot of this spread.
Figure 1.
Thanks in part to the extra “kicker” from selling expensive nearby options, this $4,000 trade has an amazingly broad profit zone. At the peak (with the underlying at 135 in just 25 days), this trade could produce a $10,000 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 second month options is greater than 10.
At the time of this writing, some of the assets that come up under such a search include ACT Manufacturing
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PowerRating). In Network Peripherals, the nearbys are at 102% while the second month’s are at 79%! This gives a substantial theoretical advantage to the horizontal debit spreader.
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 https://www.opscan.com.