Dawn Pennington

Profits on the Horizon

    Tweet This

Free Trading Guides

Suppose you think a stock is going to hit a specific price, but this move might take anywhere from six weeks to six months to take effect.

Horizontal spreads are a great option tool when you believe you know the direction a stock will move, but it's not clear exactly when.

With horizontal spreads (also called "calendar spreads" or "time spreads"), investors write (or "sell to open") a near-month call or put option and simultaneously purchase (or "buy to open") a longer-dated option in the same equity and at the same exercise price.

Basically, you're purchasing an option to hold long, just as you would a stock, and you're selling another option against it to collect some income while you wait for the stock (by proxy of the option you hold long) to make the anticipated move.

Horizontal spreads allow traders to profit from a change in the price difference in the underlying security as the option moves closer to expiration. You're buying time, literally, with the option you purchase with the later expiration date -- you can buy a LEAP, which is a long-term option that can give you up to two-and-a-half years of time, or else pick something a bit closer -- even if it's a month or two past the expiration date of the short call -- if you believe the anticipated move could come sooner.

Meanwhile, by selling the shorter-dated option, you offset the cost of the longer-dated option and aim to ensure that whether the stock moves sooner or later, you'll be well-within the window to turn a lower-risk profit at any time without all the guesswork that goes into trying to time the trade perfectly.

For example, as Apple (AAPL) increases its market share, you may start looking toward its equipment suppliers as another way to play the company's success in the PC, laptop and smartphone market. So, let's look at Broadcom (BRCM), which supplies a touch-screen controller chip for the iPhone, as an example of a potential play.

But suppose you're not sure whether the effect on Broadcom will be immediate or may need some time to play out.

To potentially profit from either scenario while lowering your risk and necessary capital to make this investment, you might choose to purchase the Broadcom January 22.50 Calls (with an expiration date of January 2010) for a $5 debit and sell the Broadcom November 22.50 Calls for a $3 credit, which would result in a net cost of $2 to initiate the trade. (Please note that this is for illustrative purposes only.)

The January 2010 calls you bought have more time value, with several more months left until expiration and, therefore, a greater chance of working in your favor, than the November calls you sold.