Box Spread Options Trading

There is a multitude of strategies for options trading. Each is designed to cater to varying market conditions and trader objectives.

One such sophisticated strategy that has gained prominence for its potential to exploit arbitrage opportunities is the box spread options trading. This strategy involves a combination of a bull call spread and a bear put spread. Thus, it creates a box-shaped payoff diagram and is utilized to capitalize on mispricing in the options market.

In this article we will explore the intricacies of box spread, unraveling its mechanics, advantages, disadvantages, and practical applications. The material below aims to provide a comprehensive understanding of this complex yet potentially lucrative trading strategy.

Key Takeaways

• A box spread, or long box, involves buying and selling contracts to create a box-shaped payoff diagram, aiming to profit from the difference in the exercise prices at expiration.
• The strategy is neutral, meaning it can generate profits regardless of market direction.
• The strategy is employed when the options prove to be incorrectly priced, allowing traders to lock in a guaranteed profit.
• Box spreads can also be used as a hedging tool to protect against adverse price movements in the underlying asset.
• While box spreads offer the potential for profit and versatility in various market conditions, they are complex and require a deep understanding of options trading. There is also the risk of loss and the potential for high costs due to the multiple transactions involved.
• Box spreads differ from iron condors, which are in contrast designed to benefit from low market volatility.

What Is a Box Spread?

A box spread, also known as a long box, is a neutral options strategy. Essentially, it combines a bull call spread and a bear put spread. This combination results in a box-shaped payoff diagram, which is where the strategy gets its name.

Both bull call and bear put spread involve purchasing contracts of the same type but at different strikes. Thus, the strategy aims to profit from the difference between the strike prices of the contracts.

Box Spread Explained

As we mentioned above, box spread is a combination of a bull call spread and a bear put spread. Let's break down each component to understand how a box spread works.

A bull call spread involves purchasing an ITM call at a premium A while simultaneously selling an OTM call with a higher strike price and collecting a premium A1. Both options have the same expiration. This strategy is used when the trader anticipates a moderate increase in the price of the base asset.

Conversely, a bear put spread involves buying an ITM put at a premium B while simultaneously selling an OTM put with a lower strike price and collecting a premium B1. Again, both options have the same expiration. This strategy by contrast is employed when the trader expects a moderate decrease in the price of the base asset.

Typically, both these spreads involve an initial cash outflow as a result of the premiums paid, because A > A1 and B > B1. Thus, the box spread would have a net cash outflow at the initiation of the strategy. The profit of the strategy would equal then the difference between strikes minus the premiums paid. Let’s take a look at the example illustrating the profit calculation.

Example

Consider a stock currently trading at $50. A trader decides to set up a box spread by executing the following trades:

Bull Call Spread:

Buy a $45 call for a premium of $6.

Sell a $55 call for a premium of $2.

Bear Put Spread:

Buy a $55 put for a premium of $7.

Sell a $45 put for a premium of $3.

Now, let's calculate the net premium paid for the box spread:

Net premium for the bull call spread = Cost of buying $45 call – Income from selling $55 call = $6 – $2 = $4

Net premium for the bear put spread = Cost of buying $55 put – Income from selling $45 put = $7 – $3 = $4

Total net premium paid for the box spread = Net premium for bull call spread + Net premium for bear put spread = $4 + $4 = $8

Now, let's analyze the potential outcomes:

• If the stock price is above $55 at expiration, the $45 call will be worth $10, and the $55 call will be worth $0. The $55 put will be worth $0, and the $45 put will be worth $0. The total value of the box spread will be $10.
• If the stock price is below $45 at expiration, the $45 call will be worth $0, and the $55 call will be worth $0. The $55 put will be worth $10, and the $45 put will be worth $0. The total value of the box spread will be $10.
• If the stock price is between $45 and $55 at expiration, the $45 call will be worth the difference between the stock price and $45. The $55 call will be worth $0. The $55 put will be worth the difference between $55 and the stock price, and the $45 put will be worth $0. The total value of the box spread will still be $10.

In all scenarios, the value of the box spread at expiration is $10. Since the trader paid $8 to set up the spread, their profit will be:

Profit = Value of box spread at expiration – Net premium paid

= $10 – $8 = $2

Therefore, regardless of where the stock price ends up at expiration, the trader will make a profit of $2, as long as the options are priced as described in the example. This is the essence of a box spread – it allows the trader to lock in a guaranteed profit due to incorrect pricing of the contracts.

How Do Box Spreads Work?

A box options strategy creates a position that can potentially generate a risk-free profit. It is employed when the trader determines that the options are incorrectly priced. Mispricing can occur when the price (premium) of the combined options is not in line with the difference between the strike prices. In such cases, the box spread can be used to exploit this discrepancy and generate a profit.

Neutral Strategy

The box spread is a neutral strategy, meaning it is not dependent on the direction of the market. Whether the market goes up or down, the potential profit from a box spread remains the same.

This is because the bull call spread and the bear put spread offset each other. If the market goes up, the bull call spread will generate a profit, and the bear put spread will result in a loss, and vice versa.

Exploiting Mispricing

The key to a successful box spread is identifying mispricing in the options market.

Mispricing occurs when the combined premium of the options contracts involved in the box spread is lower than the difference between the strikes of the contracts.

When there is a mispricing, the trader can set up a box spread to lock in a guaranteed profit.

When To Use?

Box spreads are an optimal strategy in specific market conditions and scenarios. Here are some instances when a trader might consider employing a box spread:

• Mispricing. Typically, traders set up a box spread to lock in a guaranteed profit by exploiting the options’ incorrect pricing. Mispricing occurs when the combined premium of the contracts involved in the box spread is not in line with the difference between the strike prices of the options. That is, when the price of the options is below their fair value.
• Hedging. Box spreads can also be used as a hedging tool to protect against adverse price movements in the underlying asset. By creating a box spread, the trader can offset the potential losses from other positions in their portfolio. This is because the box spread is a neutral strategy that is not affected by the direction of the market, thereby providing a level of protection against market volatility.
• Versatility in Various Market Conditions. The box spread is a versatile strategy that can be employed in different market conditions. Whether the market is bullish, bearish, or neutral, a box spread can be used to potentially generate a profit. This makes it attractive for traders who want to have a flexible strategy that can adapt to changing market dynamics.

Advantages and Disadvantages

Box spreads, like any trading strategy, come with their own set of advantages and disadvantages. Let's explore these in detail.

Advantages

• Potential to Profit from Market Inefficiencies. One of the primary advantages of box spreads is the potential to profit from mispricing or inefficiencies in the options market. When there is a discrepancy between the combined premium of the contracts and the difference between the strike prices, a trader can lock in a guaranteed profit.
• Risk-Free Strategy. Box spreads are a neutral strategy, meaning they are risk-free. The profit does not dependent on the direction of the market.

Disadvantages

• Complexity. Box spreads are a complex trading strategy that requires a deep understanding of options trading. They involve multiple transactions, including buying and selling various contracts, which can be overwhelming for novice traders.
• Risk of Loss. While box spreads are designed to be a risk-free strategy, there is still the potential for loss. There is a risk of early assignment on the short contracts, which can disrupt the strategy and potentially lead to losses.
• Mispricing Risk. The strategy relies on the options being incorrectly priced. If the mispricing is due to an error or incomplete information, the strategy may not be profitable. In fact, it will even result in a loss, considering that a trader should pay the premium to initiate the strategy.

Box Spread vs Iron Condor

Box spreads and iron condors are distinct strategies, each serving different purposes and thriving in varying market conditions.

Box spreads are utilized to capitalize on arbitrage opportunities stemming from mispricing. This strategy can be applied in various market conditions to exploit inefficiencies and lock in profits.

In contrast, iron condors are designed to benefit from low market volatility. This neutral strategy thrives in range-bound markets, where it generates profits by capitalizing on the stability of the underlying asset's price. You can find an example of a trade with iron condor in our article.

While both strategies are neutral and can be employed in a range of market conditions, their core difference lies in the source of their potential profits—mispricing for box spreads and low volatility for iron condors.

Box Spreads in Futures Trading

Box spreads can also be effectively implemented in trading other financial instruments, such as futures. When applied to futures, the strategy involves the simultaneous buying and selling of futures contracts.

The underlying principle remains consistent with its options' counterpart—the primary objective is to identify and capitalize on any mispricing present in the market. By doing so, the trader positions themselves to potentially secure a profit.

This adaptation of the box spread strategy to futures trading further exemplifies its versatility and applicability across different financial instruments, all while maintaining the core goal of exploiting market inefficiencies for potential gains.

What is a Short Box Spreads Options Strategy?

A variation of the box strategy is the short box, which consists of selling two spreads: a bull call together with a bear put. Essentially, it means that, opposite to its long counterpart, the strategy requires selling ITM contracts and purchasing OTM ones.

The goal of a short box spread is also to profit from the incorrect pricing. In this case, the strategy will generate a risk-free profit if the spreads are overpriced. However, it's important to note that opportunities for arbitrage are rare and usually corrected quickly by the market.

Conclusion

In conclusion, box strategy in options are a complex but potentially profitable strategy. They can be used to exploit arbitrage opportunities and for hedging purposes. However, they require a deep understanding of derivatives trading and carry the risk of losing money. It is critical to carefully analyze the options market and understand the risks before attempting to use box spreads in practice.

FAQ

What Are the Risks of Box Spreads?

The risks of box spreads include the potential for losing money if the options are assigned before the expiration. There is also the risk the mispricing is incorrectly identified.

How Are Box Spreads Taxed?

Box spreads are taxed as capital gains or losses, depending on the outcome of the trade. It is essential to consult with a tax professional to understand the tax implications of box spreads.

How Can I Use Box Spreads in Practice?

To use box spreads in practice, it is important to have a deep understanding of options trading and pricing. Once a mispricing is identified, the trader can set up a box spread to exploit the opportunity and generate a profit.

*This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.