Box Spread is a complex options strategy. It is an arbitrage strategy in which two complementary positions are taken that balance out the risk of each other. This makes the box spread an almost risk-free strategy.
However, as a trade-off, the profit earned from the strategy is also limited.
The profit potential of box spread is almost like investing in a fixed deposit or bond, with very little or no risk. Thus, it exploits the discrepancies in options prices to obtain a risk-free arbitrage.
The box spread is constructed by combining the components of a bull call spread and a bear put spread. It has four legs and comprises of 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.
All the options have the same strike price and options expiration date. The strategy involves complementary moves and thus, any movement in one option will be offset by the other, making it risk-free. Profits are made when one asset moves slightly more in the right direction than the other.
Box spread is a market neutral strategy.
The trader does not have to know the direction in which is prices are expected to move. The spread is created and the positions have to be held until expiration in order to generate profits.
Box Spread Timing
The appropriate time to use the box spread strategy is when the spreads are considered to be underpriced as compared to their expiration values.
This happens when there is a perception about the future price movement, or when the trend is exhausted in one direction and reversal is soon to happen. However, the strategy is complicated and advanced and should preferably be used by experienced traders.
The payoff is also minimal, so the use of the strategy becomes limited.
The box spread is constructed by combining a bullish vertical spread with a bearish vertical spread.
So, when the spreads are underpriced, the bullish spread will bring in profit if the price of the underlying closes at the higher strike price. Similarly, the bearish spread will generate profit if the price of the underlying asset closes at the lower strike price.
Thus, wherever the price of the underlying closes, the box spread will definitely generate a profit, which will be the difference between the strike prices.
The ideal opportunity to use a box spread arises when there are price discrepancies in the option prices or when the put-call parity is violated. This can occur due to short-term demand shifts of the options in the market.
At this time, to cash-in on the imbalance, the box spread can be used. Although, such situations are very short-lived, so the box spread has to be put fast enough to capture the price difference.
The reward from the strategy is quite limited and is only equal to the difference in the strike prices.
Therefore, choosing the correct strike prices is critical. Also, a lot of the profit earned gets balanced out by the premiums paid. Therefore, the trader needs to analyse if the profit made will be able to exceed the commissions, before creating a box spread.
In terms of risk, a box spread is considered a risk-free strategy, as it is based on arbitrage. The upside movement of one spread is countered by the downside movement of the other spread and there is practically no loss. Thus, a box spread is a delta-neutral strategy.
Box Spread Example
Let us consider that the shares of the company R Systems International Limited were trading at ₹50 per share in the month of May 2018. At this time, the June calls and puts and valued and a bullish call spread and a bearish put spread were created.
The call spread is created by buying a call at ₹50 paying a premium of ₹1.25 and selling a call at ₹52.50 for a premium of ₹0.37. The put spread is created by buying a 52.50 put by paying a premium of ₹2.63 and by selling a 50 put for a premium of ₹1.39.
The net debit from the box spread is ₹2.12.
Now, if the price of the shares rises above ₹50, the long call and the short put will generate profit and if the price goes below Rs 50, the short call and the long put will generate profit.
Thus, the strategy is direction-neutral and delta-neutral.
The total cost of the box spread in this case is ₹2.12 and the expiration value of the box is (52.50-50)= ₹2.50.
Thus, the net profit generated from the strategy is 2.50-2.12= ₹0.38.
If brokerage and commissions are also charged on the spread, the profit may get completely eliminated. Therefore, it is important to choose the box spread as a strategy cautiously. The profit is very limited, which can get cancelled out by the premiums and commissions.
The risks are eliminated due to the arbitrage structure. Because of the profit and payoff structure like a bond or fixed deposit, the box spreads do not have a break-even.
Here are some quick benefits of using the box strategy you can make use of:
The biggest advantage of box spread is that it is a risk-free strategy. The trader does not have to worry about the losses.
The box spread is also a direction-neutral strategy. The direction of the movement of the price of the underlying does not affect the profits.
Box Spread Disadvantages
At the same time, these are a few concerns you must be aware of before using the box spread strategy in your trades:
The profit potential is very limited. The earned profits may get neutralised by the commissions and premiums paid, so it should only be used by low-fee traders.
The margin maintenance requirements of the strategy are high.
The trader needs to keep the positions open until the time of expiration to make profits; they cannot be closed before expiry.
Box Spread in a Nutshell
To reiterate, box spread may appear as a strategy with sure shot profit and no risks.
However, it is a complicated strategy that must be implemented by experienced and advanced traders only. This is because the profit potential of the strategy is very limited and in order to make that profit, the correct timing, correct strike prices and the lowest cost of trading are very critical.
In case you are looking to get started with option trading or share market investments in general, then let us assist you in taking that forward.