Because of the market’s unpredictability, it is impossible to time it right. You never know when external forces impact tradable assets’ prices. If your trading strategy relies on a single-directional approach, the risk of the capital loss is high. Instead, your focus should be to profit from price differentials by taking a reverse position in futures on the underlying assets. This is where the concept of the horizontal spread comes in.
What is Horizontal Spread?
Horizontal spread, also known as a calendar spread, is a trading strategy that involves purchasing a futures contract in one month and investing in an identical underlying asset contract to sell in another month. Such a strategy provides more predictable insight into how the asset’s price will fluctuate. The risk associated with this strategy is relatively low, and traders frequently employ it to mitigate loss due to volatility.
The horizontal spread strategy necessitates significant capital at the time of execution. Hence, rather than small retail investors, they are more appealing to high-net-worth individuals.
How does Horizontal Spread work?
The horizontal spread strategy is popular in both futures and options trading. Understanding the mispricing of your preferred contract is crucial. You can determine this by calculating the fair value of the existing month contract, followed by the far month contract. Then, based on the mispricing, sell the overpriced futures contracts and buy the underpriced ones.
The overpriced and underpriced contract can be for the current month or a far month. The ‘cost of carry’ approach is ideal for determining whether a stock is over or undervalued. It is the cost of keeping your position until the contract expires. Another method is the ‘basis’ approach, which requires you to subtract the contract’s future price from the spot price.
Horizontal spread example–
Assume ABC Ltd is a publicly traded company on the exchange. You purchase its April futures contracts for Rs 3,000 and sell ABC Ltd. June futures contracts for Rs 3,050. In this case, the horizontal spread is Rs 50, and you expect the spread to widen due to volatility, allowing you to profit.
On expiration, the April futures price increased to Rs 3,060, while the June futures price rose to Rs 3,080. In the former, you earn Rs 60, while in the latter, you lose Rs 30. But since you have multiple positions in ABC Ltd. futures, your net profit here would be Rs 30 (a positive move of Rs 60 in April futures minus a negative movement of Rs 30 in June futures).
What are the features of Horizontal Spread?
- Minimal risk: The horizontal spread strategy is low-risk trade. That is because you have short and long positions both in the underlying assets. Even a strong bullish or bearish trend will not result in a capital loss if the contracts for different months move in lockstep.
- Low profit: It has the element of low profit that perfectly suits the low-risk factor of this type. To increase profits, you must trade in large volumes, which is why institutional investors and HNIs prefer it.
Benefits and Drawbacks of Horizontal Spread
As with any options strategy, horizontal spread carries advantages and disadvantages:
- Price Certainty and Stability: A horizontal spread provides you with a clear picture of your maximum potential profit and loss right from the start.
- Reduced Initial Investment: By selling one option while buying another, horizontal spread lowers your initial capital outlay.
- Customisation: You have the flexibility to choose different strike prices and expiration dates that align with your specific objectives and preferences.
- Credit Risk: There’s a potential exposure to credit risk, as one party may default or fail to fulfill their obligations.
- Reduced Flexibility: You are bound by the terms of the spread agreement, limiting your ability to take advantage of favourable market movements.
Potential Legal Disputes: Ambiguity or disagreements over the interpretation or enforcement of the spread agreement can lead to legal complications.
A horizontal strategy is a low risk as long as you book profits on both trades. If you only focus on one contract and have a naked position, or better say, not hedging your risk on the other, your position will be considered more speculative. A naked position on one contract makes you vulnerable to losses.