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
- = (60-55) *100
- = $500
Since the value is greater than the expiration value we can use the small box strategy to attain the profit.
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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
= 1150 – 500
= $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 –
