What is a Box Spread?

Explanation

It is an arbitrage technique where four trades are involved in a combination of two spreads, i.e., bull call spreadBull Call SpreadA bull call spread refers to a trading strategy where the trader speculates a limited price appraisal of the stock. Here, the trader bets on the same stock via two call options for the upper and lower strike price range.read more 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.

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 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 spreadBull Call SpreadA bull call spread refers to a trading strategy where the trader speculates a limited price appraisal of the stock. Here, the trader bets on the same stock via two call options for the upper and lower strike price range.read more 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 four 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 strike priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read moreprice 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 overpriced, we can attain profit by selling the box, and this type of strategy is termed as a 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 contractsOption ContractsAn option contract provides the option holder the right to buy or sell the underlying asset on a specific date at a prespecified price. In contrast, the seller or writer of the option has no choice but obligated to deliver or buy the underlying asset if the option is exercised.read more for this stock are made available at a premium price as below:

Given:

Solution:

Buy Jan 55 Call: $8

Sell Jan 60 Call: $2

Sell Jan 55 Put: $2.50

Buy Jan 60 Put: $8

Lot Size (Shares): 100

First, we will calculate Bull Call Spread

  • = Buy Jan 55 call – Sell Jan 60 call= (8100) – (2100)= $600

Now taking the Buy Bear Put Spread,

  • = Buy Jan 60 put – Sell Jan 55 put= (8100) – (2.5100)=$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.

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 spreadBull Call SpreadA bull call spread refers to a trading strategy where the trader speculates a limited price appraisal of the stock. Here, the trader bets on the same stock via two call options for the upper and lower strike price range.read more. The payoff associated with box spread is minimal, 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 condorIron CondorIron Condor is a derivative strategy designed to earn profit in a limited loss and a limited profit basis. It consists of four options – long call, short call, long put and a short put, all with the same expiration date, however, are of different strike prices.read more, on the other hand, is a neutral strategy that is also not suitable for beginners. It, too, has four transactions involved. It is a credit spreadCredit SpreadCredit Spread is the yield gap between similar bonds but with different credit quality. If a 5-year Treasury bond yields 5% and a 5-year Corporate Bond yields 6.5 percent, the gap over Treasury is 150 basis points (1.5 percent ).read more where upfront credit is received. This is used when we are under the 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 investorsRetail InvestorsA retail investor is a non-professional individual investor who tends to invest a small sum in the equities, bonds, mutual funds, exchange-traded funds, and other baskets of securities. They often take the services of online or traditional brokerage firms or advisors for investment decision-making.read more, 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 traders 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 gaining 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.

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

  • Bear Put Spread ExampleCredit Spread Option StrategySpread BettingOption Adjusted Spreads DefinitionBear Spread