Horizontal spread

A vertical spread changes the strike and keeps the expiry. A horizontal spread does the reverse: same option type, same strike, different expiry months. It is also called a time spread or a calendar spread.

Because both legs share a strike, they share an identical intrinsic value at every possible spot rate — whatever the underlying does, the intrinsic values cancel exactly. What is left is pure time value. That is what makes the horizontal spread a different animal from every other spread in the syllabus: it is not a bet on where USDINR goes, it is a bet on how the gap between two premiums behaves.

The trader's view is that the difference in time values between the near leg and the far leg will shrink or widen. He sells the leg he thinks will decay faster and buys the one he thinks will hold its value.

The workbook is explicit that you cannot draw a payoff diagram for this position, and the reason is worth understanding: a payoff chart plots profit at one expiry date, and this position has two.

Time value is highest for a long-dated option and decays towards zero as expiry approaches — and it decays faster as expiry gets nearer, not at a steady rate. The near leg therefore bleeds value quickly while the far leg bleeds slowly.

The standard construction is to sell the near month and buy the far month at the same strike. The far option costs more, so the position opens at a net debit, and because intrinsic value cancels, that debit is precisely the extra time value you are buying.

The position does best when the underlying sits near the strike at the near expiry: the short leg dies worthless while the long leg still holds most of its time value. It does worst when the underlying runs a long way in either direction, because a deep in-the-money or deep out-of-the-money option is almost all intrinsic value or almost none — either way, very little time value, and the gap you bought collapses.

Net debit = Far-month premium − Near-month premium

Same strike ⇒ intrinsic values identical ⇒ they cancel:
Net debit = Far-month time value − Near-month time value

Value at near expiry = Far-month premium then
                     − max(Spot − Strike, 0)      [short call settled]
                     + Near-month premium received

Contract value in rupees = quoted premium × 1,000 (USD 1,000 a USDINR contract).

USDINR spot is 83.00. A trader expects it to stay near 83 for the next fortnight, then get interesting. He builds a horizontal spread on the 83.00 call:

On 10 contracts (USD 10,000) the outlay is Rs 3,700.

Both legs strike at 83.00, so at any spot the two intrinsic values are identical and cancel. With spot at 83.00 both intrinsic values are zero, and the whole 0.37 is time value: Rs 370 a lot is what 49 extra days of optionality cost.

Outcome 1 — the market obliges and USDINR is 83.00 at April expiry.

April 83.00 call : expires worthless, keep the 0.18   = +0.18
June  83.00 call : 49 days left, now quoted 0.42
                   sell it: 0.42 − 0.55               = −0.13
Net                                                   = +0.05

+0.05 a dollar = Rs 50 a lot = Rs 500 on 10 contracts, a 13.5% return on the Rs 3,700 committed. The short leg's entire time value was collected; the long leg gave up only part of its own.

Outcome 2 — USDINR runs to 84.00 by April expiry.

April 83.00 call : settles at intrinsic 1.00, received 0.18  = −0.82
June  83.00 call : now quoted 1.15 (1.00 intrinsic + 0.15 time)
                   sell it: 1.15 − 0.55                      = +0.60
Net                                                          = −0.22

−Rs 220 a lot, −Rs 2,200 on 10 contracts. The direction was irrelevant; what killed the position is that a deep in-the-money June call carries only 0.15 of time value instead of the 0.42 it had at the money. The spread collapsed because time value collapsed, which is the only thing this position was ever exposed to.

Chapter 5 (Strategies using Exchange Traded Currency Derivatives), section 5.3.2, defines the horizontal spread and names its two synonyms — time spread and calendar spread. Section 5.3.1 places it in the three-way family with vertical and diagonal spreads.

The examinable points are almost always definitional, and they are the three the workbook states: same type, same strike, different expiries; the rationale is the shrinking or widening of the difference in time values; and no payoff chart can be drawn, because the legs expire on different dates. Questions that ask you to identify a spread from its two legs are answered by checking the strikes first — same strike means horizontal.

• Same strike, different expiry. Reverse it and you have described a vertical spread. Different in both is a diagonal spread.
• No payoff diagram exists. A question offering a horizontal-spread payoff chart is testing whether you know that — the legs do not share an expiry date, so there is no single date to plot.
• This is not a directional trade. Marking it "bullish" or "bearish" is the commonest error; it is a view on time value, and it loses on a large move in either direction.
• Do not confuse it with the exchange's calendar spread order facility or with the calendar spread charge in margining. Those are futures mechanisms; this is an options strategy that happens to share the word.
• Maximum loss is not simply the net debit. Unlike a vertical spread, the short near leg can be settled against you while the long far leg has not yet expired, so the two are not locked together.
• Both legs must be the same type — two calls or two puts, never one of each.