Box Spread (Long Box) Explained

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Box Spread (Long Box)

The box spread, or long box, is a common arbitrage strategy that involves buying a bull call spread together with the corresponding bear put spread, with both vertical spreads having the same strike prices and expiration dates. The long box is used when the spreads are underpriced in relation to their expiration values.

Box Spread Construction
Buy 1 ITM Call
Sell 1 OTM Call
Buy 1 ITM Put
Sell 1 OTM Put

Limited Risk-free Profit

Essentially, the arbitrager is simply buying and selling equivalent spreads and as long as the price paid for the box is significantly below the combined expiration value of the spreads, a riskless profit can be locked in immediately.

Expiration Value of Box = Higher Strike Price – Lower Strike Price

Risk-free Profit = Expiration Value of Box – Net Premium Paid

Example

Suppose XYZ stock is trading at $45 in June and the following prices are available:

  • JUL 40 put – $1.50
  • JUL 50 put – $6
  • JUL 40 call – $6
  • JUL 50 call – $1

Buying the bull call spread involves purchasing the JUL 40 call for $600 and selling the JUL 50 call for $100. The bull call spread costs: $600 – $100 = $500

Buying the bear put spread involves purchasing the JUL 50 put for $600 and selling the JUL 40 put for $150. The bear put spread costs: $600 – $150 = $450

The total cost of the box spread is: $500 + $450 = $950

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The expiration value of the box is computed to be: ($50 – $40) x 100 = $1000.

Since the total cost of the box spread is less than its expiration value, a riskfree arbitrage is possible with the long box strategy. It can be observed that the expiration value of the box spread is indeed the difference between the strike prices of the options involved.

If XYZ remain unchanged at $45, then the JUL 40 put and the JUL 50 call expire worthless while both the JUL 40 call and the JUL 50 put expires in-the-money with $500 intrinsic value each. So the total value of the box at expiration is: $500 + $500 = $1000.

Suppose, on expiration in July, XYZ stock rallies to $50, then only the JUL 40 call expires in-the-money with $1000 in intrinsic value. So the box is still worth $1000 at expiration.

What happens when XYZ stock plummets to $40? A similar situation happens but this time it is the JUL 50 put that expires in-the-money with $1000 in intrinsic value while all the other options expire worthless. Still, the box is worth $1000.

As the trader had paid only $950 for the entire box, his profit comes to $50.

Note: While we have covered the use of this strategy with reference to stock options, the box spread is equally applicable using ETF options, index options as well as options on futures.

Commissions

As the profit from the box spread is very small, the commissions involved in implementing this strategy can sometimes offset all of the gains. Hence, be very mindful about the commissions payable when contemplating this strategy. The box spread is often called an alligator spread because of the way the commissions eat up the profits!

If you make multi-legged options trades frequently, you should check out the brokerage firm OptionsHouse.com where they charge a low fee of only $0.15 per contract (+$4.95 per trade).

Short Box

The box spread is profitable when the component spreads are underpriced. Conversely, when the box is overpriced, you can sell the box for a profit. This strategy is known as a short box.

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Box Spread

What is a Box Spread?

Box spread is a type of strategy used in arbitrage where there is a combination of two spreads and four trades i.e. buying bull call spread in a combination of a bear put spread and typically both the spread have the same strike price and also the same date of expiry.

Explanation

It is an arbitrage technique where four trades are involved in a combination of two spreads i.e. bull call spread and bear put spread. The profit/loss here is calculated as a net of a single trade only. The total cost of the box remains constant irrespective of the deviation of prices of underlying securities. The expiration is here calculated by the difference in prices of the strike of the options considered in the trade. There are primarily two types of strategy which are known as long box strategy and short box strategy.

How does it work?

  • It is also called the long box strategy. It is an arbitrage technique where four trades are involved in a combination of two spreads i.e. bull call spread and bear put spread. The profit/loss here is calculated as a net of a single trade only. The total cost of the box remains constant irrespective of the deviation of prices of underlying securities.
  • This is generally used when the spreads are a lot below their prices when compared to their value on expiry. It essentially involves 4 trades i.e. Buy 1 ITM Call, Sell 1 OTM Call, Buy 1 ITM Put and Sell 1 OTM Put. The prime aim of this trade is to derive a limited risk-free profit. The buying and selling continue by the arbitrager as long as the price of the box is reasonably below the combined expiry value of the box. Thus in this way, a riskless profit can be booked.
  • The expiration value of the box is defined as the difference between a higher strike price and a lower strike price. The risk-free profit can be calculated as the difference between the expiration value of the box and the net premium paid. The short box strategy is applicable when the components of the spread are under-priced. When the box itself is much overpriced we can attain profit by selling the box and this type of strategy is termed as short box strategy.

Example

Let us understand the below example.

Let us assume a stock that is currently trading at a price of $50 for December. The available option contracts for this stock are made available at a premium price as below:

Given:

Solution:

First, we will calculate Bull Call Spread

  • = Buy Jan 55 call – Sell Jan 60 call
  • = (8*100) – (2*100)
  • = $600

Now taking the Buy Bear Put Spread,

  • = Buy Jan 60 put – Sell Jan 55 put
  • = (8*100) – (2.5*100)
  • =$550

Total Spread Cost

  • Buy Bull Call Spread + Buy Bear Put Spread
  • = $600 + $550
  • = $1150

Expiration Value

Since the value is greater than the expiration value we can use the small box strategy to attain the profit.

In case if the box spread is less than the expiration value, then we can calculate the profit by using a long box strategy.

Profit

= $650

The net profit is calculated by excluding the brokerage and taxes from the profit obtained.

When to use Box Spread Strategy?

  • Considering the example above we can see how the box plot strategy changes depending on the expiration value and the box spread value. When the expiration value is higher than the box spread value we use a long box strategy and similarly if it is the other way round we use the short box strategy.
  • This strategy is typically used when the spread is under-priced in combination with the expiration amount. It generally combines a bear put and bull call spread. The payoff associated with box spread is minimum so the use of this strategy also becomes very restricted and should be used only by experienced traders.
  • The best occasion to use this strategy is when there exists a difference in prices in the option price or when the put-call balance is affected which can be a cause of shift of short term demand for options. Here choosing the correct strike price is the key to making money as the benefit of this strategy is generally driven by the difference in the strike price.

Difference Between Box Spread and Iron Condor

  • It is an arbitrage technique where four trades are involved in a combination of two spreads i.e. bull call spread and bear put spread. The profit/loss here is calculated as a net of a single trade only. The total cost of the box remains constant irrespective of the deviation of prices of underlying securities.
  • The expiration is here calculated by the difference in prices of the strike of the options considered in the trade. There are primarily two types of strategy which are known as long box strategy and short box strategy.
  • Iron condor on another hand is a neutral strategy that is also not suitable for beginners. It too has four transactions involved. It is a credit spread where upfront credit is received. This is used when we are in an assumption that there will be very little movement of the price of the security.
  • Unlike, like box spread here we have more chances to make maximum profit. To generate maximum return the underlying security should bear the same pricing and should be within a specified range.

Advantages

  • The prime advantage of this spread is that very low risk is associated with it since it is used to earn a minimal profit.
  • It is the best strategy when the expiration value is more than the spread value.

Disadvantages

  • The profit earned is really very low and minimal.
  • The strategy is only helpful for experienced investors and not retail investors where a lot of knowledge is required to take such a call.
  • The margin required to apply this strategy requires a huge margin and maintenance of it which small trader will find it tough to maintain.
  • The trader has to keep waiting for the expiry by getting the money stuck in the box spread.
  • It is very difficult to spot such opportunities in the trade market and take advantage of it.
  • Discrepancies of price get net off very fast and thus taking advantage of such discrepancies is very tough.

Conclusion

As mentioned earlier it is a useful arbitrage strategy provided the trader is willing to take a minimum risk and also make a minimum profit. Here the experience level required pulling such strategies and gain benefit out of it is also a matter of concern. Generally experienced traders will be applying such strategies and make a profit out of it. The timing required to utilize such a strategy is the key to making money out of it.

Recommended Article

This has been a guide to What is Box Spread and its Definition. Here we discuss how does Box Spread work, along with examples and its advantage and disadvantages. You can learn more about derivatives trading from the following articles –

Box Spread (Long Box) – Option Trading Strategy

September 15, 2020 @ 12:00 pm

Cole Turner

A box spread, also known as a long box, is an option strategy that combines buying a bull call spread with a bear put spread, with both vertical spreads having the same strike prices and expiration dates.

The long box is used when the spreads are underpriced in relation to their expiration values. By reading this article, an investor will gain a basic understanding of this complex option trading strategy.

The box spread is constructed by buying one “in-the-money” call, selling one “out-of-the-money” call, buying one “in-the-money” put, and selling one “out-of-the-money” put. Because four options are included in this strategy, the cost of executing this strategy is very high.

By combing a bull call spread and a bear put spread, it does not matter where the underlying security’s price expires. The potential profit is always going to be the difference between the two strike prices minus the cost of the options.

Example

Assume stock ABC is trading at $100.

First, an investor buys an “in-the-money” call option with a strike price of $97 for $5 per share. Secondly, he buys an “in-the-money” put option with a strike price of $102 for $5 per share. Thirdly, he sells an “out-of-the-money” call option with a strike price of $102 for $3 per share. Lastly, he sells an “out-of-the-money” put option with a strike price of $97 for $3 per share. All four options have the same expiration date in a month.

From these transactions, the investor faces a cost of $4 per share (5 + 5 – 3 – 3 = 4).

If ABC closes at $100 in a month, then the call and put options that were “in-the-money” would be exercised. The other two options would expire as worthless. From the call option, the investor would make $3 per share. From the put option, the investor would make $2 per share. After accounting for the cost of entering this strategy, the investor walks away with a profit of $1 per share (5 – 4 = 1).

If ABC closes at $110 in a month, then both call options would be exercised. Both put options would expire worthless. The investor will make a profit of $13 from the call option that he bought. He will lose $8 from the call option that he sold. From these two options he makes a profit of $5 per share. After accounting for the cost of entering this strategy, the investor walks away with a profit of $1 per share.

If ABC closes at $90 in a month, then both put options would be exercised. Both call options would expire worthless. The investor will make a profit of $12 from the put option that he bought. He will lose $7 from the put option that he sold. From these two options he makes a profit of $5 per share. After accounting for the cost of entering this strategy, the investor walks away with a profit of $1 per share.

From these scenarios, an investor can see that whether the stock’s price rises or falls, the investor will profit as long as the difference between the strike prices is greater than the cost to enter the trade. Since this strategy deals with four options contracts, the cost to enter the trade is very high.

Investors who have a high capital should use this advanced option trading strategy to generate profits.

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